Stock Market Newbies, This Guide Is For You : Planet Money

SYLVIE DOUGLIS, BYLINE: This is PLANET MONEY from NPR. (SOUNDBITE OF BRICE MONTESSUIT'S "LOST SITUATION") CARDIFF GARCIA, HOST: Hello, and welcome to Season 2 of PLANET MONEY Summer School, a course about big economic ideas without the big textbook - in fact, no textbook. This season of Summer School is all about investing. Every Wednesday between now and Labor Day, we are going to bring you a new class about the markets that people invest in, like the stock market, the bond market, cryptocurrencies and more. And we're going to explain the basic ideas that you need to know about them, like how these markets affect the economy, the risks of investing in these markets and whether it's appropriate to invest in some of these markets at all so that you can make wise decisions in your own life about your own investments. My name is Cardiff Garcia. I'll be your Summer School host. And before you get too excited, by the way, this is absolutely not a series that will show you how to get rich. We at PLANET MONEY are the wrong people for that because we've done a lot of investing experiments through the years and, well... (SOUNDBITE OF ARCHIVED NPR BROADCAST MONTAGE) JACOB GOLDSTEIN: So we lost $9. HANK MENDELSON: Not terrible. GOLDSTEIN: Not terrible, he says. But the price of gold went up, and we lost $9. GARCIA: Oh, my God. The value of our Ethereum has plummeted. STACEY VANEK SMITH: Wait - what? ALEX GOLDMARK: So that means of your hundred dollars, you get $99.84 back. GARCIA: Of course, making money was never the point of all those experiments. The point was to understand the often-baffling world of investing a little bit better. And that's also the goal of PLANET MONEY Summer School. So throughout the series, we are going to be listening to some classic PLANET MONEY episodes to learn about the financial lessons hidden inside. And we'll be discussing those lessons with some world-class professors - for today's class, two such professors. Allison Schrager is a senior fellow at the Manhattan Institute, a think tank, and she's the author of a book about risk-taking called "An Economist Walks Into A Brothel." Allison, hello. ALLISON SCHRAGER: Hello. Thanks for having me. GARCIA: And our second professor is Mihir Desai. He teaches finance at Harvard Business School and is the author of his own book called "How Finance Works." Mihir, welcome. MIHIR DESAI: Hey. Great to be here, Cardiff. GARCIA: Well, let me ask both of you a question to kind of kick off the whole series. Let's say we were right now in a classroom and I gave each of you a chalk - because apparently this is a classroom from the 1950s, OK? - and I said, hey, can you each write on the chalkboard one really big lesson that you would want students to take away from a summer school series about investing? Allison, what do you think that lesson should be? SCHRAGER: I'd be like, investing's about risk. GARCIA: That investing is about risk. SCHRAGER: Yes. GARCIA: OK. What does that mean? SCHRAGER: Well, because the point of investing is moving money through time, right? You want to move money into the future. GARCIA: By that, you just mean that choosing not to spend the money today and not to just let the money sit in a bank account. Instead, what you're talking about is taking a risk with the money and investing it because you hope to have more money in the future if your investments pay off. But, of course, by taking a risk, you might also lose money. That's what it means to take a risk. SCHRAGER: Exactly. And either it's going to be bigger, smaller or the same. So if you take more risk, it will - might be bigger, but it also might be smaller. But if it's going to be the same, it's probably because you didn't take any risk at all. GARCIA: OK. Mihir, what do you think is the big lesson? DESAI: Yeah, so learning about investing is not just learning about stocks. Learning about investing is about a lot of the big decisions you make in your life - buying a home, buying an education, really doing anything that requires you to think about risk and return. GARCIA: And that brings us to today's class - the stock market and a cow named Penelope. We are going to ask a question that sounds really simple, and yet the answer is not at all simple or obvious. The question is, where do stock prices come from? Today, we will present two theories about what determines the price of a stock - two theories that seem to contradict each other, even though it's possible that both theories are right. Class one of PLANET MONEY Summer School begins right after this. (SOUNDBITE OF DAVE JAMES AND KEITH BEAUVAIS' "HEAVY LOAD") GARCIA: OK, we're back. Everybody, please take your seats. PLANET MONEY Summer School is now in session. Today, we are going to look at how the stock market works. So, Allison, Mihir - here is where I want to start, OK? Let's say the three of us pooled our money together and we decided to buy some shares of, I don't know, Microsoft stock, right? What exactly do we have now? SCHRAGER: Well, you own a little piece of Microsoft, so you have a claim on all their future profits. GARCIA: A claim on future profits. Yeah. We should explain this to our students. So Microsoft, of course, makes products. It sells those products. And then, after it pays for all its costs, like paying its workers and buying equipment and things like that, it has money left over. Those are the profits. And so as owners of Microsoft, we have a claim on those future profits, which, of course, sounds like a pretty good deal. But, Mihir, we said before that investing is also about risk. So where does the risk come in? DESAI: With a stock, you're saying, I'm paying $100 today, and I sure hope it's going to be worth what I think it's worth tomorrow. You have to guess. GARCIA: And that actually leads us to our first theory of how a stock price is determined, which is that it comes from all of these different investors trying to guess how good a company is going to be in the future, even if their individual guesses are all completely different. And to understand how this process works, we are now going to listen to a PLANET MONEY episode from 2015. (SOUNDBITE OF ARCHIVED NPR BROADCAST) DAVID KESTENBAUM: Francis Galton was the kind of person who believed in experts - you know, people who had studied things, people who knew stuff. He figured they knew things that ordinary people just did not. I mean, of course they did, right? GOLDSTEIN: Obviously. One day, Galton goes to a country fair. This is about 100 years ago in England. And there's this contest going on at the fair - guess the weight of the ox. Galton's a scientist and a statistician, and he figures, hey, I can do an experiment here, right? He figures, I'm going to take everyone's guesses, take the average and compare that to the actual weight of the ox. KESTENBAUM: We heard this story from James Surowiecki, who writes about economics for The New Yorker. JAMES SUROWIECKI: He thought what you were going to end up with was a really flawed guess because in his mind, what you were doing was you were taking guesses of a few smart people, a few mediocre people and then a lot of morons - 'cause he basically thought everyone was dumb. KESTENBAUM: (Laughter). SUROWIECKI: So he figured the group's guess was going to be way, way off the mark. KESTENBAUM: The contest organizers gave Galton the little slips of paper with everyone's guesses on them. He took them, calculated the average. The average was 1,197 pounds. And the ox? SUROWIECKI: The ox weighed 1,198 pounds. KESTENBAUM: (Laughter). SUROWIECKI: So that, in other words, the crowd's judgment was essentially perfect. KESTENBAUM: One pound off? SUROWIECKI: One pound off. GOLDSTEIN: This is super creepy, right? (LAUGHTER) GOLDSTEIN: Like, what's going on here? Is there some kind of, like, collective unconscious magic? KESTENBAUM: It's like a Ouija board or something, right? But the idea that underlies this - it is everywhere. It's the idea of the stock market - you know, thousands of random people buying and selling shares. Like, when you hear that Apple's stock went up or the Dow plunged, that's basically people guessing the weight of an ox. GOLDSTEIN: Yeah, it's everywhere, right? It's the price of oil. It's the price of orange juice. All kinds of things that are really important to the world work exactly this way. KESTENBAUM: But why should it work? Why should a bunch of random people, a lot of whom have no idea what they're doing, somehow magically produce an answer that makes sense? Does this really work? And if it does, why does it work? GOLDSTEIN: Hello, and welcome to PLANET MONEY. I'm Jacob Goldstein. KESTENBAUM: And I'm David Kestenbaum. Today on the show, Mr. Galton, we redo your experiment. GOLDSTEIN: We came up with a plan to repeat Galton's experiment. Find a fair and a cow and a big scale to weigh the cow. And then... KESTENBAUM: (Laughter) In secret - in secret. GOLDSTEIN: And then we were going to throw the question out to the crowd - ask the world, how much does this cow weigh? KESTENBAUM: We didn't want to just limit it to people at the fair. So we figured we'd take some pictures, post them online and ask the whole world to guess. A few weeks ago, we went to the Burlington County Farm Fair in New Jersey. We met Penelope, the cow in the dairy tent. She was sitting quite happily on a bunch of hay. Kirsten Kuzmitch was taking care of her. GOLDSTEIN: Can you just describe what she looks like? KIRSTEN KUZMITCH: Yeah. She's mostly black. She has white legs, and she has a white spot in the middle of her head. But she's a big black cow (laughter). KESTENBAUM: What did you just say? GOLDSTEIN: I said holy cow, without even realizing what I was saying. She's much bigger. She just stood up. She's walking out of the barn now, and she's way bigger than I thought when she was sitting down. KESTENBAUM: We took some pictures of you, Jacob, standing next to the cow for scale. And just for fun, we decided to ask people at the fair how much they thought Penelope weighed. As it happened, it was kids day, so there were a lot of kids around. UNIDENTIFIED CHILDREN: Hi, Penelope. KESTENBAUM: Which was fine, you know. They're nonexperts. What's your name? CALEB: Caleb (ph). KESTENBAUM: How much do you think Penelope weighs? CALEB: Six pounds. KESTENBAUM: How did you come up with that number? CALEB: Because I'm 6 years old. GOLDSTEIN: You guys want to guess how much this cow weighs? KARIN: Sixty-hundred pounds. GOLDSTEIN: Like 6,000. KARIN: Yes. GOLDSTEIN: OK. Do you know how much you weigh? KARIN: Not at all. KESTENBAUM: (Laughter) I'm sympathetic. Looking at Penelope, I had no idea how much she weighed. Like, I didn't even know how to think about it. Did she weigh more than my car? Did she weigh less than my car? I don't even know how much my car weighs. GOLDSTEIN: (Laughter) More than a cow. I'm going to say more than a cow. We found an older group of kids. And, yeah, they also guessed on the low side. But they had this bigger problem, this really more worrying thing. And it was a problem that adults also seemed to have. And it was this - the first kid said a number, and then all the other kids said basically the same number, numbers that were, like, too close to the first kid. KESTENBAUM: (Laughter) It's like they were incapable of guessing anything different. ESA: My name's Esa (ph). GOLDSTEIN: And, Esa, how old are you? ESA: I'm 10. KESTENBAUM: OK, and how much do you think that cow weighs? ESA: Two-hundred pounds? GABRIELLA: My name's Gabriella (ph). I'm 10. And I think the cow weighs 300 pounds. KALEB: My name is Kaleb (ph), and I'm 7 years old. And I think the cow weighs 300 pounds. KESTENBAUM: Oh, Kaleb (laughter). People are not that different from cows. We herd. If we don't know something, we look for a leader, even if the leader maybe doesn't know anything. GOLDSTEIN: Penelope finished chewing, and we took her over to be weighed. KUZMITCH: Easy. Oh, oh, oh. GOLDSTEIN: OK, it's 1,355 pounds. KUZMITCH: We're good? KESTENBAUM: One-thousand-three-hundred-and-fifty-five pounds. We walked Penelope back to the dairy tent, and then we went home. GOLDSTEIN: The next day, we posted photos online of... KESTENBAUM: Of the cow and you. GOLDSTEIN: And me, right. I was there to give some sense of perspective. KESTENBAUM: We put you on the tractor scale. GOLDSTEIN: Yes, 165 pounds. That's how much I weigh. KESTENBAUM: (Laughter) Then our colleague Quoctrung Bui here put it all up online - guess the weight of this cow. GOLDSTEIN: And the idea was - our hope was that lots and lots of people would guess because the fundamental question here - the thing we're trying to figure out is if you have a bunch of random people making their best guess at something, do you get close to, you know, the truth? Do you get close to the right answer? So we put it up, and we waited for the results to come in. We left this up online for five days, let people guess for five days. Our colleague Bui tallied it all up. David, you and I came into the studio. We didn't know the results, and Bui came in to give us the numbers. KESTENBAUM: First of all, how many people guessed? QUOCTRUNG BUI: So the number of people that guessed - 17,205 people. KESTENBAUM: Seventeen thousand? That's legit. GOLDSTEIN: That's good. That's good. BUI: It's as if you got, like, a small town to all guess. KESTENBAUM: Bui took those guesses, added them up and calculated the average. This was the big moment. BUI: You guys ready? One-thousand-two-hundred-and-eighty-seven pounds. KESTENBAUM: One-thousand-two-hundred-and-eighty-seven? Penelope actually weighed 1,355. GOLDSTEIN: Pretty close, right? So that's to within, like - what? - 60-ish pounds. KESTENBAUM: That was pretty impressive. GOLDSTEIN: Yeah. I mean, they're only, like, 5% off, you know? And, OK, sure, the Galton thing was one pound off. This isn't that. But remember; this is just a bunch of random people, you know, looking at this little cow picture in their Facebook feed on their iPhone. KESTENBAUM: And here's another amazing thing. When we asked people to guess, we also asked them this other question. We asked, are you an expert? Have you ever worked with cows? Because remember; Galton thought experts might be better. And 3,000-some people answered yes to that question. Jacob, you wondered, were they really, really experts? GOLDSTEIN: I made sure. These are just people clicking a button online. So we emailed a bunch of them, and we heard back. And they did seem pretty expert. You know, a lot of them were farmers. One of them mentioned the, quote, "absence of a visible udder." KESTENBAUM: Actually, a few of them mentioned that. GOLDSTEIN: (Laughter) And apparently that tells you something about how old the cow is, how much it weighs. KESTENBAUM: So how did the experts do? Here's the answer. BUI: So the average guess for the experts was 1,272 pounds. KESTENBAUM: They were worse. BUI: They were worse. KESTENBAUM: (Laughter). BUI: It's amazing. GOLDSTEIN: So OK - so maybe that is wisdom of the crowds. KESTENBAUM: To be fair, the experts were only marginally worse. But they did not beat the crowd. GOLDSTEIN: We told Surowiecki about these results, and he wasn't surprised. In fact, he writes in his book, chasing the expert is a mistake; we should ask the crowd. KESTENBAUM: And the fact that the larger crowd got it to within 5%, he said that seems about right to him. When people do versions of this experiment, asking people to guess the number of jelly beans in a jar, for instance, the crowd usually gets it to within 3% to 5%. SUROWIECKI: You know, one of the things that's interesting about this is even though I've written a book and done this experiment a number of times, every time I do it and every time I hear the results, I'm like, it's not going to work this time. (LAUGHTER) SUROWIECKI: 'Cause the idea is so counterintuitive, you know? It's pretty extraordinary in that regard. The power of this, to actually let the group arrive at really good decisions is - it's eerie. There's something eerie about it, I think. KESTENBAUM: It is eerie, right? SUROWIECKI: Yeah, it is. There's something magical about it. It seems magical, I think. It's not magic; it's just math, but it seems magical. (SOUNDBITE OF BOB BRADLEY AND RICHARD MOORE'S "DISCO DOLLIES") GARCIA: OK, and we're back. It's Cardiff. I'm here with Allison Schrager and Mihir Desai. OK, so as you heard in the episode, there is kind of this spooky, eerie but really quite effective process, right? So here's my first question. In what ways is guessing the weight of a cow similar to what happens when people are deciding whether to buy or sell a stock? SCHRAGER: Well, 'cause you have a marketplace where all these different people are bidding on stocks based on how much they think it's worth, and you do converge to this price. DESAI: And I think the big difference between the cow and the stock thing is that, you know, we can verify the weight of the cow. Like, it's knowable. And with stocks, what makes it much more interesting and fun is, well, wait a second - do we really ever know it? GARCIA: Yeah. Right. Penelope the cow has an actual weight, and that weight is not going to change just because I guessed the weight too high or I guessed the weight too low. But with stocks, it's the very guessing of the price that actually ends up setting the price. It's different. So if I look at the price of a stock and I think it's low, then I'll buy that stock at the low price, and the very act of buying the stock pushes up demand for it just a tiny bit, and then that, in turn, pushes up the price of the stock. And so in the stock market, you get thousands and thousands of people doing that over and over, and that is what sets the price of a stock on the stock market. DESAI: Exactly right. There's a whole set of things we can debate about any company and its future, and that is what we're all trying to do in financial markets. GARCIA: So you've got all these people who are thinking about buying the stock because they think it's going to go up. You've got all these other people who are going to sell the stock because they think it's going to go down, and it arrives at something in the middle. SCHRAGER: Roughly, yeah. GARCIA: OK. And how can this still work if at least some of the people buying and selling a stock either don't know much about the company or just might not be very good at analyzing companies in general, given that they're supposed to be investing based on how good the company is? DESAI: Well, so first thing, the mistakes that people make kind of cancel each other out, right? The reason it's important for all of us is the price of that stock actually really matters for the world because people make decisions based on it - not just savings decisions, but you might go work for a company because you think it's going to be a good company to work for; you might buy a company's products because they're doing well. So these prices send signals into the world about what we should do. SCHRAGER: So if the prices are correct, then the market's sending that money to the best places for the right price. GARCIA: Yeah. And when you say that the price is correct, Allison, you mean that the price of the stock is a good reflection of how good the company is, how well you can expect it to perform in the future. But what if the price is higher than that or lower than that? How does that distort the process? SCHRAGER: So if a company is completely over- or undervalued, then, you know, maybe it gets too much or too little capital, and it doesn't put it in the right place because there's a finite amount of investment in the world, right? There's only so much money people can invest, so you want to make sure it goes to the most worthy places. GARCIA: OK. So that is one theory of how stock prices are set - a lot of people constantly guessing, some guessing high, some guessing low, some guesses better and more informed than other guesses. But what they're guessing is how good the company is, how well it's going to perform in the future, how much money it's going to be able to make in the future. (SOUNDBITE OF LAETITIA FRENOD'S "DIAMONDS AND PEARLS") GARCIA: But there is this other theory, a theory that says that what people are guessing when they invest in the stock market does not actually have much to do with how good the company is. It's a theory that the stock market is not like guessing the weight of a cow; it's more like a beauty contest. And to test that theory, we've got another PLANET MONEY experiment coming right up when class continues. (SOUNDBITE OF BELL) GARCIA: Everyone, welcome back from recess. Please take your seats. You are now about to hear a PLANET MONEY story from 2011. David Kestenbaum and Adam Davidson are going to test a theory about the stock market proposed in the 1930s by the economist John Maynard Keynes. (SOUNDBITE OF ARCHIVED NPR BROADCAST) ADAM DAVIDSON: Keynes said that a way to think about how the stock market works is to think of it like an unusual beauty contest. Now, people who've read the masterful biography of Keynes by Robert Skidelsky know that Keynes' romantic interests were generally directed at men. But in this case, he imagined a beauty contest of women. KESTENBAUM: So the contest he imagined would work like this. It would be in a newspaper where you put six photos of different women, and then you ask the newspaper readers to write in with their vote. And this is the important part - you get a prize if you pick the most popular face. DAVIDSON: And the reason this is a good proxy for the stock market is - think how the stock market works. So you might go around and look at different companies and say, boy, I think Coca-Cola really should be worth $50. And, boy, I really like the chances of GE growing in the future. I think they're going to be worth more in the future. But the rational, logical investor thinks about something else, as well. They think, well, I have my view of how healthy these companies are, but if the rest of the world has a more optimistic view, they think these companies are going to do even better than I do, that is sort of a self-fulfilling prophecy. I should invest not based on what I myself think but what everyone else thinks. And this issue of people casting their vote effectively, spending their money in a market based not on what they themselves think is right, but based on what they think other people think is right, is what some people thought could lead to bubbles and manias and many of the distortions that we've seen in the markets lately. KESTENBAUM: So Keynes was thinking about this in terms of a beauty contest, where he was pointing out that the rational, logical thing to do is to try to pick the woman that you think everyone else is going to pick, not necessarily the person you think is the prettiest. In fact, the person who's the prettiest might not actually win. Here, I'll read from what he wrote. Quote, "It is not a case of choosing faces that, to the best of one's judgment, are really the prettiest, nor even those that average opinion genuinely thinks the prettiest. We've reached the third degree, where we devote our intelligence to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practice the fourth, fifth and higher degrees." PIETRA RIVOLI: He's just talking about sort of some kind of strange exponential psychological process. KESTENBAUM: This is Pietra Rivoli, who gave us the idea to test this out. She's a professor at the McDonough School of Business at Georgetown University. RIVOLI: I'm trying to figure out what you think, and you're trying to think - figure out what the next guy think, and that guy's trying to figure out what the other guy thinks and so forth and so on. So, you know, I guess, theoretically, we could go around the world doing this with nobody really thinking for themselves. KESTENBAUM: So instead of deciding what I think the stock should actually be worth, I'm thinking, what does Pietra think? Or I'm thinking, what does Pietra think that Adam thinks that Caitlin thinks? RIVOLI: Exactly, exactly. And, you know, again, the key danger is that nobody's really thinking. DAVIDSON: So we decided to do our own beauty contest. We wanted to test this idea that if people are voting based not on what they personally think is beautiful and valuable but based on what they think other people will think is beautiful, how does that change the dynamic? How does that change how things are valued? And we decided not to use the beauty of human beings. And, David, I'm just going to say this 'cause I think it's part of the experimental study, what our thinking was - or at least my thinking was. I'm clearly the most beautiful member of the PLANET MONEY team, and my feeling was I would just get 100% of the vote. It wouldn't be statistically significant, and it might hurt morale. KESTENBAUM: Yeah. DAVIDSON: So David, you had the brilliant idea of us focusing not on human beings but on animals, and not focusing on beauty but on cuteness. Pietra Rivoli helped us design the experiment, and she explains. RIVOLI: So we have three animals. We have a kitten, who's very cute. We have some baby polar bears - or a mama and a baby maybe - also very cute. And we have something called a loris, which is an animal I wasn't familiar with. And the loris is - surprise - also cute. KESTENBAUM: So the loris - can I just speak up for the loris, here? I think I'm a loris guy. I don't know if everyone out there has seen a loris. It - there - it's like a slow-moving monkey-type thing. DAVIDSON: I think of it more like a sloth. KESTENBAUM: No, no, no. It's like - it's definitely primate with huge, huge innocent eyes. And in this video, it is being scratched under its arm. So it's got its arms straight up above its head to sort of facilitate the scratching. It is dangerously cute. DAVIDSON: But, David, you have revealed your bias. And to avoid the bias of the test designer, the pro-loris bias, we actually constructed a much more rigorous system. People who engaged in this experiment went to a website, and they were put into two experimental groups randomly. Now, the first group was Group A. Now, if you were in Group A, you were asked to pick the animal that you think is cutest - the kitten, the polar bear or the loris - simple enough. Those people in the second group, though, Group B - the people in Group B were asked to pick the animal that they thought everyone else thought was the cutest - not their own desires, their own view, but what they think the broader view is. KESTENBAUM: So we're going to hear from someone in each group. First, for Group A, we'll just use Pietra. RIVOLI: I was in the first group, Group A. Which one do I think is cutest? KESTENBAUM: And what did you pick? RIVOLI: Oh, I have to tell you? KESTENBAUM: Yeah. RIVOLI: Oh, really? OK. (LAUGHTER) KESTENBAUM: Is it embarrassing? RIVOLI: I picked the polar bear. I liked the white fur, and I also thought that the whole skating on your belly on the ice thing was adorable. KESTENBAUM: And, Adam, here is a listener from Group B who got in touch with us. MARLA WOOD: Hi. How are you? KESTENBAUM: Good. This is Marla Wood (ph). WOOD: I actually had a hard time finding any of them particularly cute, honestly. I... RIVOLI: (Laughter) So she keeps her money in the bank. She doesn't put her money in the market. WOOD: Am I supposed to tell you what I chose? KESTENBAUM: What did you think was the cutest first? WOOD: OK, I guess the loris was the cutest. KESTENBAUM: So - but you were asked to pick the animal you thought everyone else would pick as the cutest. WOOD: Yes, correct. KESTENBAUM: So what did you pick? WOOD: I chose the cat - the kitten, I should say - for two reasons. One was it was the least appealing to me, which I find is generally the case with my experience in life. I'm always on the outside in my opinion. And then also I thought it was the most sort of understandable, accessible - you know, sort of my experience of others is the thing that they know the best. So I figured most people would pick that. KESTENBAUM: Even though you personally would have picked the loris. WOOD: Correct. KESTENBAUM: That's pretty strategic thinking. RIVOLI: (Laughter). WOOD: Yeah, that sounds like me (laughter). DAVIDSON: So even though she thinks the kitten is the least appealing, her fundamental valuation of the kitten is extremely low, she's voting for the kitten because she thinks everyone else is going to like it. All right. So, David, I have to say, it was all very exciting because you were sort of in charge of this experiment. So all of us found out the results before you did. KESTENBAUM: I didn't know that (laughter). DAVIDSON: Yeah, and you went into the studio to learn the results so that we could have your response on tape. But all of us were outside of the studio going, oh, wow. Oh, wow. He doesn't know. KESTENBAUM: All right. So Caitlin has the results, and she's going to come in here and tell us what they are. RIVOLI: OK. CAITLIN KENNEY: OK. So here we have the envelope. Open it up. You guys nervous? RIVOLI: I'm nervous. KENNEY: First, I'll read you the results of Group A. KESTENBAUM: How many people responded? KENNEY: So in Group A, we have 5,934 votes. RIVOLI: Wow. KENNEY: And taking the lion's share of the votes, we have the kitten. The kitten in Group A received 2,983 votes, which is about 50%. And hold on. I did this math earlier. KESTENBAUM: Adam, I'll just summarize for you here. The people from Group A - asked which animal do you think is the cutest? - about half of them went for the kitten. And the other half were pretty evenly split between the loris and the baby polar bear. That's Group A. KENNEY: Now, for Group B - vote for the animal you think is most likely to be voted the cutest by the other participants - the kitten has 4,516 votes. RIVOLI: Wow. KENNEY: So the kitten is 76%. KESTENBAUM: Adam, so the kitten is 76%, the loris got 15% and the baby polar bear got 9%. DAVIDSON: All right. So let's just recap. So we have two groups. Just to remember - Group A, the people who are asked to pick, what do you think for yourself is the cutest? Half of them, 50%, say kitten. The other half's split between loris and baby polar bear. KESTENBAUM: But in Group B, the more sort of strategic investors who are asked to pick what they think everyone else will pick - 76% of them correctly identify that the kitten will win. But you've got 15% thinking it's going to be the loris and 9% thinking the polar bear. DAVIDSON: And I feel like from the standpoint of wanting the world to function in a rational way, where markets work efficiently and reasonably, there's sort of good news and bad news in this story, I think. Right? I mean, so some good news is, well, 76% of Group B was right. They were correct that people voted the kitten the cutest. Now, 24% of Group B were wrong. They voted - they thought everyone was going to like the loris or the polar bear. So you can imagine, if there was a cute animal stock market - which, David, we are going to keep working on until it exists - you might get very different prices for the different animal stocks, depending on how investors are making their decisions. Are they making fundamental analysis, just looking at what they truly believe is the cutest, or are they being strategic? Are they trying to guess what everyone else is thinking? KESTENBAUM: Yeah, and I thought of a particularly extreme scenario where this all went very, very wrong. What if the market was entirely filled with Marlas, right? Then basically, you know, there's a huge kitten bubble, and no one actually thinks kittens are cute. RIVOLI: That's the danger. KESTENBAUM: A market full of Marlas. (LAUGHTER) WOOD: Oh, no. Oh, no. KESTENBAUM: But this is the other thing, right? It's not irrational. Marla is behaving completely rationally, right? You're trying to pick the stock you think is going to go up. RIVOLI: Well, we also have to put a time frame on this, you know? So I think even Keynes would say that in the long run, the prettiest beauty contestant will win. It's just that in the short term, there's a lot of noise, a lot of distortions, a lot of psychological second-guessing and so forth. KESTENBAUM: Eventually, over the long term - you know, four years, five years, 10 years - people find out what the real value is, you know - in our analogy, what the cutest animal truly is. But in the short term, which can last a long time, as we've seen, all sorts of things are happening that are not - that are totally unmoored. Because if everyone's choosing based on their true fundamental sense, that seems like a more grounded market. But if everyone's just guessing what everyone else is guessing that everyone else is guessing, then you can see how it can become kind of frothy and insane every once in a while. (SOUNDBITE OF KEN BOWLEY'S "FROTHY COFFEE") GARCIA: Hey, everyone. It's Cardiff. After a quick break, we answer the million-dollar question - is the stock market like guessing the weight of a cow, or is it like a cute animal beauty contest? (SOUNDBITE OF KEN BOWLEY'S "FROTHY COFFEE") GARCIA: And we are back. So Allison, Mihir, let's just get right to it. If the stock market is like guessing the weight of a cow, then it means that investors are trying to guess how good a company is, how good it's going to be into the future. And all those guesses are kind of magically reflected in the stock price through the wisdom of crowds. But if the stock market is more like a beauty contest, then investors are not trying to guess whether a company has a bright future. They're just trying to guess what everybody else is going to do. So which is it? SCHRAGER: Well, I think it's both right. DESAI: Yeah, I think it's exactly both those things. It's a very messy place where things often go wrong, and it's a place where ultimately things tend to get right. GARCIA: Are there any examples, say, in the very recent past, where something weird happened and the price of a stock went either way up or way down, which seems to suggest this kind of dynamic where people are just guessing what other people are going to do in the stock market, and they might be guessing what other people are going to do in the stock market and that that seems to be driving the price of a stock? SCHRAGER: Yes. I mean, in fact, that happened recently during the pandemic when you had a lot of people getting into the market who normally hadn't and, you know, were making bets on companies that didn't seem to have very good fundamental values. I mean, like a company like GameStop. I mean, I'm not even clear what they're sort of long-term growth rates would be. It doesn't look very good. But, you know, you had a bunch of people piling on, saying we're going to put money into this at first. But then all of a sudden it becomes almost rational to pile on - right? - because you know everyone else is piling on, so the price is going to go up and up and up. So, I mean, even still, you know that this price is going up and it shouldn't go up and eventually it's going to fall, but you never know how much further it's going to go up before that happens. And that's what makes it so hard. DESAI: The really crazy part comes when that story takes the next turn, which is GameStop capitalizes on the idea that lots of people love it and then they issue more stock. And then... GARCIA: They sell more stock... DESAI: They sell more stock... GARCIA: ...At that higher price. DESAI: ...At that higher price, and then they're able to pivot in their business in an interesting way. And that gives them another leg to this fantasy about what they can potentially do. GARCIA: So GameStop is essentially the kitten of the last year and a half or so. SCHRAGER: It is until it grows into a really mangy cat. GARCIA: (Laughter) OK. DESAI: (Laughter). GARCIA: So how do we know in the stock market if, in a given moment, a price reflects how the company actually is performing and is expected to perform versus these kinds of short-term pressures where people are just guessing what everybody else is guessing? SCHRAGER: Well, you don't know. You can never know for sure. So I think if you're an investor, you want to think about - are you a long-term or are you a short-term investor? - and understand short-term investing's a lot riskier? DESAI: I think the way to reconcile these two seemingly opposed ideas is just to take it over different horizons. So I think, over the long run, we can be relatively confident that hopefully prices will reflect fundamental values, and we'll see those profits and cash flows come out over time. You can believe that and also believe that over the short run, crazy stuff happens. It's just that the dynamic gets played out over different horizons. (SOUNDBITE OF ARNAUD RIGNON'S "SPACE OYSTER") GARCIA: And that wraps up the first class of PLANET MONEY Summer School. And now that you know where stock prices come from, in next week's class, we'll tell you how to apply that knowledge. But before we let you go, we actually have some vocab words that we'd like you to remember. First up, wisdom of crowds - you know, this concept that we just heard about by which all these different people trying to guess at something bring their own little bits of information to the guessing process, and those guesses end up averaging out to something pretty accurate. And the second vocab word is Keynesian beauty contest, where all the guessing is not trying to arrive at an accurate judgment, but rather people are just guessing what everybody else is guessing. And I think for this class, that might be it. Any other ones, actually? DESAI: Well, loris, for sure. I had no idea what a loris was. GARCIA: Loris. Yeah, I (unintelligible) look up loris (laughter). Excellent. Put that in your notebooks. That will definitely be on the test. This, again, is Season 2 of PLANET MONEY Summer School. If you want to catch up on Season 1, the easiest way is just to Google PLANET MONEY Summer School. You'll be taken to a page where you'll find all of last year's episodes on how to think like an economist and even a final exam for when you're done. PLANET MONEY Summer School is produced by Audrey Dilling, with help from Alexi Horowitz-Ghazi, and it's edited by Alex Goldmark. Our project manager is Devin Mellor and special thanks to Liana Simstrom. You can find us on social media everywhere as @PlanetMoney. And we do read emails at planetmoney@npr.org. Just put Summer School in the subject line, please. My name is Cardiff Garcia, and I'm the host of my own upcoming podcast called "The New Bazaar." The first episode drops August 12. PLANET MONEY is a production of NPR. Thanks for listening. Copyright © 2021 NPR. All rights reserved. Visit our website terms of use and permissions pages at www.npr.org for further information. NPR transcripts are created on a rush deadline by Verb8tm, Inc., an NPR contractor, and produced using a proprietary transcription process developed with NPR. 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