Are you competing in a beauty contest?

Discussion of the simExchange heats up on Midas Oracle following an introduction of how game stocks on the simExchange work.

Robin Hanson, widely regarded as a top mind in the development of prediction markets, points out that the simExchange game stocks do not cash out on any date. Hansons states that such a market relies on “traders of good will to enforce such a connection” between stock prices and game sales. Hanson draws the conclusion that such a connection may be lost once players realize this.

Keith Gamble, a PhD candidate in Economics at Berkeley, follows up in a post titled “simExchange a Keynesian Beauty Contest.” Gamble anticipates that the simExchange's response to Hanson’s comment would be the comparison with equities made in the original explanation of game stocks.

Gamble points out that a significant difference in the logic is that real equity shares in companies (stocks on the NYSE or NASDAQ) have real intrinsic value while game stocks do not. If a company’s stock fell low enough, a buyer (like a private equity firm) would swoop in, scoop up the company, and sell off the assets for an arbitrage that would make money regardless of how the stock market was feeling (just like Michael Douglas in Wall Street). This is something traders can do in real equity markets if the market participants become irrational and stop following the rules.

Instead, Gamble describes the simExchange as an example of a Keynesian beauty contest. John Maynard Keynes is one of the most important economists in history. Keynes described the stock market in an analogy about a beauty contest in which one must pick the most beautiful faces to win. Since everyone knows "beauty is in the eye of the beholder," your best chance of winning is choosing the faces that the average person would think are beautiful--not the faces you think are beautiful. According to this theory, rational investors need not evaluate a stock by its company's fundamentals, they only need to evaluate how other investors evaluate stocks.

There are always market participants who ignore fundamentals in the real stock market. There are some traders who buy in bubbles just hoping to sell their stock to the next fool. There are other traders who just look at charts to see patterns and formations.

Rational traders can join them in their irrationality or wait out a bubble. They can also risk exposure to more irrationality as a short seller as they know, eventually, fundamentals will take over. This occurs not because the New York Stock Exchange cashes out the stock at a lower value based on the company’s 10-K (because it doesn't), but because a build up of traders who do conform to valuing stocks by fundamentals eventually force a downward correction.

Many players realized early on that share prices on the simExchange are completely based on what other people are willing to pay:

On December 14, 2006, Dazz12345 said, “But it doesn't matter how many people [buy the game] it only matters how many people think that that every WOW player will buy it, therefore upping the price!”

On December 21, 2006, jsmrekar said, “This stock doesn’t have much to do with the real game. It is based on what people purchase the virtual stock. Meaning, if the game does well and everyone sells their stock, the stock will tank.”

Surprise from this revelation is expected as one goal of the simExchange is to help gamers learn and develop an interest in the stock market. When they started, many players did not know stock prices are based on market forces--the prices people are willing to pay for them--and instead believed stock prices are the result of calculations by a computer. However, playing the simExchange quickly teaches players how a market works.

Empirical evidence of trading on the simExchange has demonstrated at least some efficiency. One example experienced players point to for noobs is the correction in Viva Pinata (Xbox 360) stock following the emergence of November sales figures back in December 2006. The stock had risen on expectations that the game would be a sleeper hit from the very strong reviews it had received. However, sales figures came in much lower than expected and the stock plunged.

A recent example was the tumble in Kirby: Squeak Squad (DS). The game had very strong sales in December 2006 and traders had expected this to be a breakaway success. However, sales had quickly dropped off in January and traders rushed to sell off their shares to maximize the DKP they could get back.

One example of an undervalued stock correcting to the upside after a news event is the sharp rise in Call of Duty 3 (PS2) shares following surprisingly strong December sales. Traders did not expect a First Person Shooter (FPS) traditionally designed for the PC would do well on the PS2; however, when data of the contrary emerged, the stock quickly corrected upwards as traders realized they are guaranteed gains at market prices.

Players who did not trade in the direction implied by the news lost DKP while those who did gained DKP. As predicted by market theory, eventually, these players learn to trade with sales figures or they run out of money. However, like the real stock market, the simExchange is not immune to bubbles. If people become irrationally exuberant for a game, the stock may be priced very high. This is all part of simulating a stock market.

Additionally, as in any game, the admins can wield the awesome power of Non-Player Characters (NPC), in this case market makers with infinite money, that can encourage players back to rational trading.