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Popular theories that investing in indexes is the best possible strategy are not self-sufficient. If there were no active traders, then nobody would trade indiv

Popular theories that investing in indexes is the best possible strategy are not self-sufficient. If there were no active traders, then nobody would trade individual stocks. In this case, there would be no indexes to invest. So markets stay in permanent equilibrium where active and passive investors are balanced out. More precisely, if there were too many active traders, it would be attractive to become a passive investor since markets are very efficient. If there were too few active traders, it would be attractive to become an active investor since markets are not very efficient. Yet despite of this simple truth, I constantly hear from seemingly serious people that only index investing is worth doing (i.e. random walk theories pop up regularly in the press). Beating index should be hard because it's a competition! And everybody is not supposed to be winner.

qntty 10y ago
I think the more reasonable claim is that it's highly unlikely that you will beat an index fund over a (say) 40 year period, so for the average investor who is investing for retirement, it makes no sense.
jessriedel 10y ago
You're talking to the wrong people. The idea isn't that all investors should be index investing, the idea is that all investors without special expertise should be index investing. This is a non-trivial statement because one might think (and people often argue) that active managers with expertise can beat indices, and therefore unsophisticated investors should just hire those people. The problem with this is that unsophisticated investors can't tell the difference between active managers who have a real edge (be it special insight, better computers, bigger brains, etc.) and those who do not. Insofar as an active manager can demonstrate convincingly to an unsophisticated outsider that they have an edge, the manager will be able to capture the excess value by commanding larger fees in the marketplace for managers. This would be a fine equilibrium for wise unsophisticated investors, but unsophisticated investors are not all wise. Various human biases and market failures mean that there are an excess number of active investors (i.e., a number above the equilibrium value in an efficient market), many/most of whom are leeches. This is the state we find ourselves in today. The reason the number of active managers is decreasing is because wisdom is diffusing, but we are not done. It goes without saying that "special expertise" involves a lot more than reading financial newspapers and considering yourself a smart person. It's about as hard to be able to compete at that level as it is to compete in professional sports. The big difference is that the heavy dose of randomness involved in investing allows more people to convince themselves that they are able to compete with the big boys, when almost none of them are. (The evidence that you can't compete with LeBron James at basketball is harder to ignore.)
notahacker 10y ago
Theories of markets generally assume that people that should actively trade stocks are people that have a insight into aspects of the market they're trading in which is superior to that of other stock-pickers. If you're wondering whether the generic advice to buy an index fund might be better, you're not one of those people (and you should buy the index fund). Of course, plenty of professional fund managers claim to have that insight, but when they're charging higher fees for insights that on average don't beat the market, you should probably take the same view that you need enough knowledge to evaluate their trading strategy (or a strong reason to prefer a fund which claims to be aiming for low/high volatility) to consider them over the index... Since the index has lower fees and the "winners" are disproportionately likely to have information advantages, beating an index is a competition in which the average joe can usually expect to fall behind.

qntty 10y ago

I think the more reasonable claim is that it's highly unlikely that you will beat an index fund over a (say) 40 year period, so for the average investor who is investing for retirement, it makes no sense.

jessriedel 10y ago

You're talking to the wrong people. The idea isn't that all investors should be index investing, the idea is that all investors without special expertise should be index investing. This is a non-trivial statement because one might think (and people often argue) that active managers with expertise can beat indices, and therefore unsophisticated investors should just hire those people. The problem with this is that unsophisticated investors can't tell the difference between active managers who have a real edge (be it special insight, better computers, bigger brains, etc.) and those who do not. Insofar as an active manager can demonstrate convincingly to an unsophisticated outsider that they have an edge, the manager will be able to capture the excess value by commanding larger fees in the marketplace for managers. This would be a fine equilibrium for wise unsophisticated investors, but unsophisticated investors are not all wise. Various human biases and market failures mean that there are an excess number of active investors (i.e., a number above the equilibrium value in an efficient market), many/most of whom are leeches. This is the state we find ourselves in today. The reason the number of active managers is decreasing is because wisdom is diffusing, but we are not done. It goes without saying that "special expertise" involves a lot more than reading financial newspapers and considering yourself a smart person. It's about as hard to be able to compete at that level as it is to compete in professional sports. The big difference is that the heavy dose of randomness involved in investing allows more people to convince themselves that they are able to compete with the big boys, when almost none of them are. (The evidence that you can't compete with LeBron James at basketball is harder to ignore.)

notahacker 10y ago

Theories of markets generally assume that people that should actively trade stocks are people that have a insight into aspects of the market they're trading in which is superior to that of other stock-pickers. If you're wondering whether the generic advice to buy an index fund might be better, you're not one of those people (and you should buy the index fund). Of course, plenty of professional fund managers claim to have that insight, but when they're charging higher fees for insights that on average don't beat the market, you should probably take the same view that you need enough knowledge to evaluate their trading strategy (or a strong reason to prefer a fund which claims to be aiming for low/high volatility) to consider them over the index... Since the index has lower fees and the "winners" are disproportionately likely to have information advantages, beating an index is a competition in which the average joe can usually expect to fall behind.