4 ms·

Index funds buy or sell blindly, at whatever the prevailing best price is. Naturally, if there were only index funds in the market, the price would vary randoml

Index funds buy or sell blindly, at whatever the prevailing best price is. Naturally, if there were only index funds in the market, the price would vary randomly. That being said, consider what would happen if stock prices did start to vary randomly - if you had actual research suggesting the price was too high or too low, you could trade accordingly. This would net you a profit, and also help push the price in the opposite direction, towards whatever a reasonable price is. The larger the deviation from the "correct" price, the larger the potential profits are to be had. So if the problem ever starts to be significant (i.e. a few cents of deviation caused by index funds), this means a very large potential profit for any active funds or traders out there. And so we would expect the system to reach an equilibrium - where there are just enough active funds and traders to snatch up the profits that arise from tiny price errors and distortions caused by index funds. In effect, the index funds are paying those remaining active funds and traders a tiny "management fee" (in the form of exploitable trading behavior) to figure out the appropriate price of stocks for them!

gcb0 9y ago
stock prices Do vary randomly.
- rjtavares 9y ago
  I'm assuming that is a reference to the random walk theory. That theory suggests that "the past movement or trend of a stock price or market cannot be used to predict its future movement". It's random in the sense of unpredictable, not in the sense of actauly being determined by chance. The implication of the random walk theory is that current information is already uilt into the price of the stock. That is only true insofar as there are active traders acting on that information. The parent is merely explaining why those traders will exist, and why you only need a small part of the market to actively trade.
- hueving 9y ago
  Random walk depends on all participants acting rationally based on the same information released at the same time. However, index funds are not rational, they always buy in the same ratios regardless of news.
  - aangjie 9y ago
    I'd suspect all those HFT firms will have robot agents (trading based on some ratios/logic) as simulations for their testing environment.
deleted 9y ago
[deleted]
galfarragem 9y ago
Resuming, as I understand it: Good stock pickers > Index Funds (blind money) > Bad stock pickers By investing on index funds you are betting in the average of the average (a fund is already an average of undervaluated and overvaluated stocks). However, by investing on managed funds your probability of having profits over index funds is low: even if stock pickers that beat the market (by definition) amount to 50%, extra fees make most of them still less profitable to investors than passive funds. [edited]
- VMG 9y ago
  > Why not invest on a good stock picker? You can only tell them after the fact
  - galfarragem 9y ago
    Sure, but I still prefer to bet on Buffett than on a managed fund that is consistently beated by the market. [edited]
    - spcelzrd 9y ago
      Buffett would take the other side of that bet. http://longbets.org/362/ http://longbets.org/362/
      - GFischer 9y ago
        Pretty close to finishing. Is Buffett still winning?
        icebraining 9y ago
        He made a recap last year, was winning by quite a bit: https://www.yahoo.com/news/buffett-most-mportant-investment-lesson-211351601.html?ref=gs https://www.yahoo.com/news/buffett-most-mportant-investment-...
        9y ago
hvis 9y ago
But the "correct" price is the one the investors are willing to buy at, right? Imagine that 99.98% of all investors are index funds, and there is a company BigCo that is at some point is at the top of the market. So pretty much every index fund invests in it. Then suppose BigCo makes some move that would traditionally be a mistake. Like it has some scandal, the sales drop off, etc. Say it even has a bad quarter. How do I, an active investor (among the remaining 0.02%), make profit from the arbitrage? For the stock price of the company to fall, there'd have to be no buyers at the given price. But the index funds will keep investing in it. Why would it drop off even a little?
- jpetso 9y ago
  Even if it doesn't drop off, you can make money by investing into businesses who give you better long-term growth and (related) dividends than the one that everyone else is buying through index funds which you know isn't doing well. This would require a long-term view similar to how Berkshire Hathaway is acquiring businesses. If active investors' short-term price speculation were reduced in favor of long-term bets, that might be a good thing for businesses and the economy overall. And of course, if this situation actually becomes commonplace, chances are the market for index funds is going to self-correct since a well-performing stock needs either solid dividends or above-average growth. A market with 100% indexing can not give you above-average growth, and dividends depend on actual business performance.

gcb0 9y ago

stock prices Do vary randomly.

rjtavares 9y ago
I'm assuming that is a reference to the random walk theory. That theory suggests that "the past movement or trend of a stock price or market cannot be used to predict its future movement". It's random in the sense of unpredictable, not in the sense of actauly being determined by chance. The implication of the random walk theory is that current information is already uilt into the price of the stock. That is only true insofar as there are active traders acting on that information. The parent is merely explaining why those traders will exist, and why you only need a small part of the market to actively trade.
hueving 9y ago
Random walk depends on all participants acting rationally based on the same information released at the same time. However, index funds are not rational, they always buy in the same ratios regardless of news.
- aangjie 9y ago
  I'd suspect all those HFT firms will have robot agents (trading based on some ratios/logic) as simulations for their testing environment.

deleted 9y ago

[deleted]

galfarragem 9y ago

Resuming, as I understand it: Good stock pickers > Index Funds (blind money) > Bad stock pickers By investing on index funds you are betting in the average of the average (a fund is already an average of undervaluated and overvaluated stocks). However, by investing on managed funds your probability of having profits over index funds is low: even if stock pickers that beat the market (by definition) amount to 50%, extra fees make most of them still less profitable to investors than passive funds. [edited]

VMG 9y ago
> Why not invest on a good stock picker? You can only tell them after the fact
- galfarragem 9y ago
  Sure, but I still prefer to bet on Buffett than on a managed fund that is consistently beated by the market. [edited]
  - spcelzrd 9y ago
    Buffett would take the other side of that bet. http://longbets.org/362/ http://longbets.org/362/
    - GFischer 9y ago
      Pretty close to finishing. Is Buffett still winning?
      - icebraining 9y ago
        He made a recap last year, was winning by quite a bit: https://www.yahoo.com/news/buffett-most-mportant-investment-lesson-211351601.html?ref=gs https://www.yahoo.com/news/buffett-most-mportant-investment-...
        9y ago

hvis 9y ago

But the "correct" price is the one the investors are willing to buy at, right? Imagine that 99.98% of all investors are index funds, and there is a company BigCo that is at some point is at the top of the market. So pretty much every index fund invests in it. Then suppose BigCo makes some move that would traditionally be a mistake. Like it has some scandal, the sales drop off, etc. Say it even has a bad quarter. How do I, an active investor (among the remaining 0.02%), make profit from the arbitrage? For the stock price of the company to fall, there'd have to be no buyers at the given price. But the index funds will keep investing in it. Why would it drop off even a little?

jpetso 9y ago
Even if it doesn't drop off, you can make money by investing into businesses who give you better long-term growth and (related) dividends than the one that everyone else is buying through index funds which you know isn't doing well. This would require a long-term view similar to how Berkshire Hathaway is acquiring businesses. If active investors' short-term price speculation were reduced in favor of long-term bets, that might be a good thing for businesses and the economy overall. And of course, if this situation actually becomes commonplace, chances are the market for index funds is going to self-correct since a well-performing stock needs either solid dividends or above-average growth. A market with 100% indexing can not give you above-average growth, and dividends depend on actual business performance.