Kevin: You bring up an interesting topic. Some financial authors (John Bogle and William Bernstein, at least) actually have a name for active fund managers whose investments are substantially identical to index funds. They call them “closet indexers,” and apparently they’re more common than one might guess.

And you’re absolutely right, they have no hope of beating the market. But they probably won’t get fired (at least not too quickly) because they’ll never have a year in which they underperform it by several percentage points.

Clearly, the active managers have to invest outside of (or at least in different proportions) than the index, or they wouldn’t be able to sell themselves on supposedly beating the index.

Yes, we pay for several years of earnings when we purchase a stock. But pretty much everyone everywhere is willing to do that for any asset that has earnings. Which explains why, years later when we sell our shares, we’ll find people willing to do exactly what we did. At that point we’ll get paid for several years of *current* earnings, so over the long haul our gains will be driven by earnings growth, Q.E.D.

Active traders are surely somewhat responsible for the volatility of P/E ratios, but those ratios stay in a pretty well-defined box – even if it’s big – and they travel the length of that box more than once in an ordinary person’s retirement investing horizon. There is nothing an individual investor can do to change that. But changing *earnings* moves the entire P/E box itself; it makes the company worth more at the same P/E ratio or even – over the long haul – at a smaller one. And those results are about the company, not the investor or his peers.

In the short-run, market action is ALL about supply and demand.

In the long-run, its ALL about earnings.

Nice discussion.

Do VCs need investors to sell and buy every day? Do LLCs need high turnover to make their money? Do you need people to sell their CDs early to increase your return? No, No, and No. While traders do create short-term returns even for long-term investors, long term investors are only looking for a cut of actual earnings and long term appreciation of the company. High turnover trading has no bearing on these factors.

So yes, they play a role in the game, but they are not needed for long-term returns.

What I’d argue, however, is that this isn’t necessarily a good thing for other investors. The more a person pays for an investment, the lower his rate of return will be on that investment.

In other words, lower demand is a positive thing for a significant group of investors (those who are still planning on buying more stocks).

Also, I really like your example of a stock price falling to zero. In the (clearly hypothetical) situation in which a stock price is $0 for a company that’s still earning money, investors would still be earning a non-zero rate of return. They’d still be earning dividends.

And, in fact, for anybody who buys the stock after it hits a price of $0, they’d have an infinite rate of return. ($x dividends / $0 share price = infinite rate of return.)

Permanently high stock prices (ie, a permanently high P/E ratio for the entire market) aren’t a good thing except for people who have already bought all the stocks they ever plan to buy. For every generation after them, permanently lower P/E ratios would provide better returns, right?

With that said, the P/E is ALWAYS more than 1 so we will always pay for the future. With active managers, they end up creating more demand via liquidity and that causes more interest from other people as a better investment than alternatives (treasuries, real estate and whatever else) and hence more buying.

More buying = high stock prices even with the same earnings because the market at the end of the day about supply and demand (ie if there isn’t a single person that wants to buy the stock and no one owns any, the stock price will be bid down to $0 no matter what earnings it is)