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I always thought that the role of the stock market is the collective intelligence of a large pool of investors, that allocates resources to the most effective o
by cft 9y ago
I always thought that the role of the stock market is the collective intelligence of a large pool of investors, that allocates resources to the most effective or highest performing businesses. Index investing is a blunt instrument that does not allow investors to resource-allocate on the fine-grained individual business level. In the best case, it's more like the Soviet central planning, where a handful of people selecting which stocks comprise an index do most of the financial planning. In the worst case, it causes bubbles- the only decision power there is buy/sell , the detailed microeconomic information about individual businesses is almost irrelevant to the investors.
- golemotron 9y agoThe bubble reference is particularly apt. It's a bunch of people saying "I'll do what they are doing."
- rhombocombus 9y agoWhile this is true, there is a lot of value in individual investors investing in index funds, and their performance has borne that out. I don't think that individual investment is going anywhere any time soon. For an investment product that is stable and has more distributed risk, however, index investment can't really be beaten, or rather it hasn't been beaten yet.
- kolbe 9y agoFree riders. And there's good reason to believe that the future of investment will not have a group of corporate governors to free ride off of going forward.
- cloakandswagger 9y agoIt's chicken or egg: index funds are successful because people invest in index funds, therefore index funds are... There will be an inflection point where stocks in indexes are so overvalued that enough active investors (and passive defectors) cause a rebalancing. If they're overvalued enough, and enough of the general market participates in them, index funds could easily crash. Apps like Robinhood are making active investing much more feasible for your average Main Street person. I certainly am not counting on the continued blind investment in index funds.
- cat199 9y ago> It's chicken or egg: index funds are successful because people invest in index funds, therefore index funds are... This presumes that the only reason stocks are in the index is because of index investors, which is not the case.
- xemdetia 9y agoI agree with this as a principal. There was even some good commentary a while ago when an article about all the money flowing into Vanguard https://news.ycombinator.com/item?id=14145308 https://news.ycombinator.com/item?id=14145308. A market with no active players defeats the efficient market idea. There should be some sort inflection point where the index fund critical mass is, but I don't think we've had this sort of situation in a modern economy before.
- kolbe 9y agoA market with no knowledgeable and empowered corporate governors also causes distortions. https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2992046 https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2992046
- adventured 9y agoThere's no such thing as collective intelligence, although the Soviet system is the specific system that professed collectivism to be the ideal. There is only individual intelligence, which can act with other individuals. That is, there are only individual investors - actors - whether we're talking about retail or hedge funds or even AI bots. There's no seven million headed investor automagically sharing a brain and its accumulated wisdom. The point being, each investor that is acting on the market, is acting from different conclusions (even off of exactly the same data), with different intent, and with different capability of deduction and discipline and implementation and so on. Most of the professional investors that manage money for others are not very good at generating returns. They tend to be horrible at taking advantage of the vast market inefficiencies that made Warren Buffett and dozens of other famous examples possible. To make matters much worse, said mediocre professional investors then make their money by skimming off the capital they manage. When that's your scenario, index investing will always make sense. The only time it doesn't, is if you possess numerous rare attributes that make it possible to take advantage of the inefficient market, or if you can find a rare someone to trust your money to that can do so.
- cft 9y agoBy "collective intelligence" I meant the net vector of each individual investor's decisions. Maybe not the best choice of words. In the case of index funds, those individual decision vectors are pre-alligned by the "central planners" who compose indices from individual stocks.
- stcredzero 9y agoThey tend to be horrible at taking advantage of the vast market inefficiencies that made Warren Buffett and dozens of other famous examples possible. How does one find market inefficiencies? Elon Musk's First Principles analysis is one thing that comes to mind.
- a_c_s 9y agoThis is far more applicable to traditional, actively-managed mutual funds than it is to index investing. In a mutual fund a handful of people select the stocks to invest in and do so arbitrarily. Sometimes there are specific goals or sectors in mind but other times it is just to chase performance. In an index the goal is to buy everything of a kind: all of the stocks in the S&P500 or all of the stocks listed on the NASDAQ. A handful of people aren't arbitrarily deciding which of the 500 biggest companies are. The goal of the index investor is to get average performance - active traders can worry about the microeconomics. If too many people index invest then there will be huge market inefficiencies for active traders to make money on, which will attract more traders to the market, which will make the market more efficient.
- josh2600 9y ago>A handful of people aren't arbitrarily deciding which of the 500 biggest companies are. Right... https://www.cnbc.com/amp/2017/08/01/sp-500-to-exclude-snap-after-voting-rights-debate.html https://www.cnbc.com/amp/2017/08/01/sp-500-to-exclude-snap-a... Edit: note that Fortune 500 and the S&P 500 are not the same list.
- olau 9y agoI've been thinking the same. Are there any consumer-oriented products that lets you pick your own index? As in: you select the stocks and their proportion and supply the money/demand money out, and stocks are then bought/sold automatically? Say I want to follow index X, but I don't want stocks in oil or coal companies because I believe they're going to die before I need the money out. There doesn't seem to me to be an easy way to build that customized index. I guess you need a low-fee stock broker and an algorithm that's aware of the fees for this to not end up drowning in fees.
- jopsen 9y agoRobinhood let's you trade for free, and quantopian.com provides a python based platform for automated trading with support for robinhood. Have fun,
- olau 9y agoIt does sound fun, but apparently I'm still in the wrong country for Robinhood. And to be honest, in this case I would trade some fun for something with a GUI. :)
- kbutler 9y agoRobinhood's primary interface is a mobile app with a GUI. Not great for research, but functional to buy/sell.
- digikata 9y agoHow are they sustaining that free trading? If it's on VC money, then I worry what exactly happens to shares if the firm shuts down. Who is actually holding the shares becomes a critical question in that circumstance. Edit: I see a $110M Series C in April '17 reported for Robinhood.
- mi100hael 9y agoYou can pay like $10 a month for their "Gold" offering. Gets you margin (which also nets them some money) & after-hours trading.
- EliRivers 9y agoWhat allocation? After the first time it is sold, the stock being traded around provides zero resources to businesses.
- hsk 9y agoThat's not the right way to look at it. People invest in an IPO in the first place because of the promise of liquidity down the line. If investors were told that they couldn't freely buy or sell shares after the first time it is sold, the IPO is going to do far worse. The ability to trade the stock around directly helps the company by making the IPO more successful. That's not even considering that the company could issue secondary offerings.
- OscarCunningham 9y agoSo if I invest in Facebook now, I'm helping them by making it easier for them to raise money several years ago? In some kind of weird acausal way, because people then anticipated my actions now?
- tome 9y agoNo, you're helping pre-IPO companies raise money now.
- ncallaway 9y ago> In some kind of weird acausal way, because people then anticipated my actions now? They didn't anticipate _your individual_ actions, but it's highly likely that the persons that bought into Facebook's IPO did expect that they would be able to sell the stock to _someone_ at a later date. So, yes, people anticipated your actions now (if you look at _your_ actions as the general actions of the crowd, instead of your individual actions)
- gnode 9y agoIf you invest in a stock with the intention of selling it later, rather than holding it forever to earn the dividends, your decision was motivated by the expectation that there will be a market for it in the future. By buying Facebook stock now, you're fulfilling that expectation of earlier investors, which motivated them to provide Facebook's initial funds.
- bronz 9y agoactually the stock market and other investment markets (and credit markets) serve to offset the effect of money-saving on the cyclical flow of money through the economy. if people saved a lot of money and saved it all in cash, there would be less money available in the product market and would result in a downward spiral of high prices and low employment. the stock market solves this problem by re-injecting saved money as investment into the pockets of companies. please be aware that i am new to economics so i may be mistaken.
- fsargent 9y agoIt depends on how they saved it. If people put it under their mattress it would be a problem. If they keep it in a bank (which offers an interest rate) the bank can loan that money out again, which massively increases the money supply. The stock market is a far smaller market compared to credit and loan markets.
- bronz 9y agooh thanks
- Y7ZCQtNo39 9y agoCompanies don't get the money, so you're not really investing in the company directly unless you on the primary market (e.g., pre-IPO). You buying stock on a secondary market doesn't give the company more capital to work with.
- ComodoHacker 9y agoDoesn't it give the company higher valuation and higher chances to attract more capital?
- acdanger 9y agoYes. But isn't the IPO most often represent the biggest capital inflow of a company's life typically? How would any post-IPO debt issuance or sales of stock compare to the cash generated from the IPO.
- didgeoridoo 9y agoUnless you're Apple, which raised about $100M in its IPO, and currently makes about $500M in revenue per day.
- acdanger 9y agoThat's not directly tied to their stock price though. Apple could suffer a corporate scandal tomorrow and their stock price could fall 20% and revenues could be largely unaffected. I just don't follow the reasoning that stock price enables resource allocation.
- bandrami 9y agoIt doesn't; you're exactly right. It's something people who hold for value (i.e. baseball cards or tulips) rather than for income (i.e. dividends, or what people used to hold stocks for for centuries) tell themselves.
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- oli5679 9y agoThis fallacy is discussed in detail in the article. Indexing (provided it is below 100%) does not increase the noise of prices, since the universe of active and passive investors are not trading with each other (except for some edge cases which are not significant). This means that increasing in indexing does not necessarily harm the resource allocation service provided by investors, until everything becomes really weird close to 100% passive indexing.
- cft 9y agoClearly at 0.0001% indexing is negligible, and at 100% there's no longer an effective stock market allocating resources based on microeconomics indicators. But what is the critical threshold of indexing that interferes with efficient resource allocation? 99%, 50%, 3%?
- peteretep 9y agoIf you can accurately show it's interfering with resource allocation, you can make a huge huge profit by buying under valued stocks, and rebalance the market.
- Armisael16 9y agoThe market can stay irrational...
- peteretep 9y agoIt never needs to get rational to profit off its irrationality. Any company I can buy on the cheap because the market is irrational is all good by me; I still have voting rights and dividends.
- Retric 9y ago~99%. Critically, prices change as a result of any imbalance in supply and demand for stocks. Also of note index funds do have feedback loops as they try to retain a balanced portfolio. If company A is worth 1 billion and company B is worth 2 billion yet they have equal dollar investments in both, then they sell some of A to buy some of B. This greatly magnifies the impact of active traders in a 99% ownership situation.
- hippich 9y agoSomewhat tangential - how exactly me buying, let's say, stock of AMZN, puts value where it is most effective way (in the pocket of another AMZN stock seller, and not AMZN itself)?
- rat_1234 9y agoFair point! I think a way to look at it is what earnings multiples companies trade at signals to companies how much money they can raise in an IPO or follow on equity issues. For example, if Boeing is trading at 5X EBITDA then it signals to other aerospace and defense companies that they can expect to raise capital at a similar multiple. It's indirect, but it still provides a service: creating a predictable, liquid securities market which firms can use to raise capital.
- ak217 9y agoYou buying stock constitutes market liquidity. Market liquidity allows companies to do follow-on offerings, buybacks, and preferential rate debt financing (often with stock option collateral) at their leisure. It also allows companies to compensate their employees in stock options - I don't know the best financial term for this, but it creates employee goodwill. Companies periodically restructure their stock option pools (in almost the same dilutive manner as follow-on offerings) so they can continue to offer employees more stock options.
- neilwilson 9y agoSecondary markets have little or nothing to do with resource allocation. The business actually has little need to get involved at all in its stock market listing if it is just getting on with its business. It's only when you start using shares as currency to buy other things (whether manpower or other companies) that secondary listings and the ability to swap them into cash starts to matter. There's a fairly reasonably argument that a stock market in its modern construction is actually more of a hindrance to genuine equity investment and it shouldn't exist. Then those investing in equity have to look at the ability of the company to generate an income rather than sell itself to the greater fool.