Confessions of an Index Investing Skeptic — Part II: Gamblers, Fools, and the Efficient Market Theory

Price is what you pay. Value is what you get.
— Warren Buffett

You can stand on the shoulders of giants, or a big enough pile of dwarves. Works either way.
— Anonymous

Devotees of index investing also tend to be strong proponents of the Efficient Market Hypothesis. There are a number of variants of the theory, but the basic idea behind it is this: the market effectively prices in all information that is realistically knowable to a non-insider. Thus the market price is always the “right” price, and it is “impossible” to consistently beat the market. Anyone who does so, adherents claim, is just lucky.

As you might imagine, I have some serious doubts about this theory, to put it mildly. But let’s set that aside for the time being, and assume that, at least until 1992 or so, it was more or less accurate.

The key thing to understand about the Efficient Market Hypothesis is that its entire foundation rests on the notion of a broad array of actors discovering all information that is knowable and relevant to the intrinsic value of an asset, then acting in aggregate on that information to provide a highly accurate real-time price. (Remember the Parable of the Ox?)

In short, it depends heavily on the idea that most people trading the assets in question are doing so based on some conception of what they are really worth. I’m prepared to believe that this held at least some measure truth for much of the stock market’s history.

What it fails to account for is the potential effect of a large and ever growing array of actors taking actions that significantly affect asset prices for reasons that have absolutely no relationship to their actual value whatsoever. If you recall from Part I, that’s precisely what index investors do. (They’re not the only ones, either. More on that to come.)

When Everyone Wants to Piggyback, No One Gets To

The very same Efficient Market Theory whose adherents claim makes active investors gamblers and fools, requires active investors to work. It’s hard to piggyback on crowdsourced pricing when no one in the crowd is actually making an effort to assess the proper prices.

We’re not quite at that point just yet, of course, but the greater the percentage of market participants who move asset prices based on anything other than what they believe the assets to be worth, the greater the risk that they’ll overwhelm the information-based investors, leaving prices to be ever more divorced from reality.

What would you expect to see in such an environment? What would drive asset prices if not some notion of their underlying value?

It’s hard to know for sure, but I’ll offer a theory: Perhaps macro conditions — perceptions about the state of the economy as a whole — would begin to take a larger role. Seems logical, right? After all, sufficient pessimism about the economy could move even the most ardent devotee of passive investing to at least shift some assets from a stock index to a bond index.

So hypothetically, if macro conditions began to dominate over individual valuations in determining price movements, what would you expect to see?

Oh, that’s right. Greater market correlations.

This is just the theory of one non-professional, non-academic, non-expert, of course, so take it for what it’s worth. But it would explain a lot, wouldn’t it?

3 Comments

  1. First post ever

    I forgot to mention the reason why I’m pessimistic about index investing in my previous post. You might decide to dig into my hypothesis a bit more, so here it is.

    There are a number of intermediaries which almost everyone needs to go through to access the stock market. Most of these intermediaries make money out of transactions and/or volatility. In other words, the suck value out of the stock market for no good reasons other than holding the keys to it.

    Now, they are far from being able right now to appropriate themselves the entire gains from the market, but I’m convinced that the share of the gains they take is increasing constantly. Their share actually doesn’t even change when the market falls. Goldman alone pays billions in bonuses annually. If you add up how much each player pays in compensation and you compare that to the gains of the entire stock market, you get their fees.

    My hypothesis is that in the long run, based on their incentive system, their fees will increase every single year, constantly reducing the average return of nix investors.

  2. Sean Owen

    Replace the word “investors” with “traders” in your comment, and we more or less agree.

    I don’t think it’s realistic to expect to beat the big boys when it comes to rapid, short term trading, in part for the reasons you mention. I’ll stop short of saying it’s impossible, but it is at best a difficult, risky, full-time occupation.

    But while the middle-men, market-makers, and high-frequency algorithmic traders can easily devour all the tiny scalping gains to be made from short term trades, the amount they siphon off on any single transaction is more or less negligible to a long-term investor.

    You could destroy that entire industry at a stroke with an extremely small tax on transactions. A few basis points is all it would take. I’d love to see it happen, too – I’m sick of seeing so many of our best and brightest minds waste their productivity on something that has at best absolutely zero social value, and at worst enormous negative value. Real investors, by contrast, would barely even notice such a tax. In fact, they’d probably come out ahead once it shook out all the bloodsuckers that currently make their fortunes milking that cash cow.

    At the end of the day, though, let them have the trading. They’re welcome to it. It’s a miserable way to spend your day, in my opinion.

    Investing, on the other hand, is alive and well.

  3. Like an ancient Roman watching a gladiator fight, I thank the active investors and benefit from their actions but I wouldn’t want to be among them.

    I’m not so sure that indexing is at the point where it can change the markets. My impression of old markets (say 100 years ago) is that a lot of activity was driven by people who were managing investments for others and had to be fairly conservative, which led to predictable and formulaic investment strategies much like indexing. Market participants also knew a lot less then. Think of pension funds today, but before they decided hedge funds and alternative asset classes were cool.

    With changes in the market structure, changes in market participants, more information, and the rise of high-frequency trading, I wouldn’t be surprised if markets are more efficient today than they ever have been in the past. The size of the finance industry relative to GDP seems to be increasing, but who’s to say that’s not at the expense of active investors?

    That doesn’t mean that markets are universally efficient. It only takes a relatively small number of emotionally-driven people to push a single stock to an unreasonable extreme. I just don’t have time to chase after that (to be more accurate, this would be far less profitable than working to invest more). In rare cases you can read the hype instantly (like Apple last year) but I don’t see that enough to base my investments on it.

    On a more practical level, you can evaluate the fundamentals of an index such as the earnings yield and the dividend yield. The popularity of certain groups of stocks does vary in a cycle, so I track several indexes that I like and allocate more money to the least popular ones. For those who know less this might not be practical but a rule-based asset allocation can still work since they benefit from the cycle through dollar-cost averaging and rebalancing.

    And if correlations are rising that’s great (note that this would be a fair sign of an efficient market where all stocks are priced correctly to start with and are in fact affected by the same macro factors). That means that when everyone decides to dump the US indexes over some political scare, all the stocks will get cheaper instead of only some. I love buying lots of cheap stocks in one move.

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