The general premise of the Efficient Market Hypothesis is that there are so many investors buying and selling securities that, at any given point, the price of each security should accurately reflect all known information about the underlying company.
Therefore, the most strict believers of EMH believe that (aside from pure luck) there is no opportunity at all for an investor to find investment opportunities that will earn above-market returns.
From what I’ve seen, however, the majority of EMH proponents today argue not that such opportunities don’t exist, simply that they’re not sufficiently common to justify the efforts and expenses involved in seeking them out.
On the other side of the discussion, some people argue that markets are not efficient, and that there most certainly are opportunities for a skilled investor to outperform the market.
Index funds win either way.
What people seem to miss is that the superiority of index funds is not dependent upon whether or not markets are efficient. Whether the people who beat the market do so via luck (as would be consistent with EMH) or via skill, there’s no question that the average dollar invested in the market will underperform the market’s return by an amount equal to the average investment costs incurred.
And, therefore, if your investments track the market while incurring below-average costs, they’ll by definition earn above-average returns.
Why not try to do better?
Of course, if markets are not efficient, then there must be an opportunity for a savvy investor to do even better than he’d do with an index fund. However, in order to outperform in an inefficient market, you’d have to either:
- have better stock picking skills than the professionals with whom you’re competing, or
- invest in a fund run by a manager who has such skills.
Unfortunately, there’s little reason to think that individual investors have any meaningful advantage over institutional investors (who have more time, more brain power, better research, and a longer time horizon than individual investors).
Also, as David Swenson (Chief Investment Office of Yale’s Endowment Fund) recently mentioned, the best professional money managers are generally not running mutual funds open to the public.
Efficient markets or not, I’m indexing.
As far as I can tell, evidence of market inefficiency isn’t meaningful evidence against the wisdom of index fund investing.
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{ 10 comments… read them below or add one }
I’m not sold on EMH. At any rate, once again you provide an able defense of index funds. You don’t need to have luck or skill to beat inflation and enjoy a comfortable return. You just have invest in index funds for the long haul.
More advice from another smart person saying I should invest in index funds…I’ll take it!
I think one problem with assuming this logic: “have better stock picking skills than the professionals with whom you’re competing”, is that I personally am investing with the goal to build my personal wealth. Those professionals could be suspected to be investing to build their “clients’” wealth, and in some cases to promote their “careers”.
This may sound cynical, but I believe the purpose of the financial services industry is to make themselves rich, while making their clients “rich enough” to keep them from doing the work themselves.
There are many reasons to assume that financial planners or brokers don’t always act in the client’s best interest (to make the client money) and those reasons have been explored in books like Liar’s Poker, or Dreman’s Contrarian Investing.
Great post again Mike!
I found a post over at canadian capitalist who also comes down to the same conclusion: http://www.canadiancapitalist.com/efficient-market-theory-and-indexing/
Market timers and stock pickers would have to argue that: with costs being equal, that they can successfully select and buy undervalued stocks and sell when they are overvalued. Something which I think has been argued that is difficult to do even for professionals.
They could also argue that indexing into inefficient markets, leads you to “automatically” invest in an asset which is over valued.
I agree that indexing makes good sense regardless of whether the market is efficient or not.
But passive indexing does not.
The only argument for not changing your stock allocation in response to big price swings is that valuations don’t matter much. If the market is not efficient, that one goes out the window.
Rob
Mike, I’m not sure your two options capture all the reasons why an individual investor might be able to exploit inefficient markets and beat the professionals?
Private investors can do things like move into cash, they can take on risk free of institutional mandates, and they are pretty much uninhibited by having too much money.
Not saying these sorts of freedoms mean stock pickers are likely to beat the pros (most are likely not to) let alone the index (I agree, most of us should track!) but it does expand out the playing field a bit…
Dave: I’m at least as cynical. Your description of the purpose of the financial services industry there sounds pretty accurate to me.
Brian: Thanks for that link. Hadn’t seen that post yet.
Monevator: Very valid points you have there about (at least potential) advantages that individual investors have. Thank you for bringing those up.
The arguments in favor of indexing are sufficient to convince most people.
But what I fail to understand is why anyone would want to take the risk of investing in the stock market – via indexing or otherwise – without hedging the risk of tosoe investment.
Sure markets tend to go up over time, but you live in only one period of time – and if stocks decline (or rise only slightly) over that time span – what are you going to do for money?
Options are the answer to cutting significant risk out of investing.
Mark: Same question as before. Can you provide evidence that options (specifically, the collar strategy that you recommend) reduce risk in a more cost efficient manner than simply reducing one’s stock allocation?
There is a joke about two effecient market acedemics from the University of Chicago walking down the street and one of them sees a twenty dollar bill and says,”Hey there is a twenty.” The second economist says, “that can’t be, in an effecient market someone would have already picked it up!” This not-so-funny joke seems to imply that there are pricing inefficiencies in the real world, but in an effecient market there is no systematic way known to human-kind to caputure them to earn returns unrelated to risk. Imagine a business plan that was designed to systematically find twenties. Markets are effecient because all of the knowable and unknowable information are factored into prices today and only new news will change prices going forward. Love your site – keep telling the truth!