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?

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