To truly understand the power of index funds we must first understand how the stock market works. Any discussion of investing must first start with the fundamentals that modern economics applies to the stock market. There are two competing theories about how the stock market works or does not work, depending on your perception. Despite their differing views, both of the economists who developed them ended up winning a Nobel prize for their respective work in the same year. After looking at these views more closely, you may find that they easily co-exist rather than compete.
Efficient Market Theory
The first theory is the efficient market hypothesis. This theory came to prominence in the 1970s by the economist Eugene Fama. This theory portends that the prices of the stock market are efficient, i.e. all known and relevant information is reflected in the price of a stock. The reason, this theory states, is if the market was not efficient then an opportunity for risk free money would exist that would quickly be snatched up. As such it should not be possible to “beat the market”.
Behavioral economics as explained by economist Robert Shiller states that not all man’s actions are rational. Interpreted in some ways this invalidates the possibility of the market being efficient. A common example is a dropped hundred dollar bill on the ground. Under similar arguments to the efficient market, one would never pick up the money on the ground. Why? There would be no chance it would be real because someone would have already picked it up. Behavioral economics became more popular in recent years in light of the dot com bubble.
A Random Walk and Short Term
As stated previously, one can interpret the 2 theories as competing. However, I personally believe that is not necessarily the case, and there is evidence to support this view. Efficient market theory contains another theory entitled random walk. This theory states that stock prices evolve randomly, meaning that beating the market and market timing are not possible. I personally believe this theory is true in the short term. The outcome on any given day of a stock price is completely random. Many studies have observed and found this to be true. Studies that have raised concerns about these theories tend to be based on a longer period of time. For example, some studies at 10 years have shown trends in stocks that appear to invalidate the theory.
Long Versus Short Term
I view this relative inconsistency as largely in line with my views on economics as a whole. The economy and stock market are largely predictable over the long term barring a war or collapse of government, but over the short term the predictability is about on par with flipping a coin.
Implications for Index Funds
What this means is if you define the medium term you can market time and beat the market. So why do almost all studies show that active managers do not “beat the market”? Simply because like other areas of economics the definition of short term and long term cannot be known. You see this in common sense truism around the market: “The market can stay irrational longer then you can stand solvent” (John Maynard Keynes). Even in a world of the Dotcom bubble you could have missed making a lot of money for years before the bubble burst had you pulled out due to overprice. Predicting when the bubble would burst was impossible. The famous “Irrational Exuberance” speech by Allen Greenspan was long before the bubble implosion, had you pulled out at the time of that speech you would have missed out on 2 -3 more years of ups.
Best bet to Invest in Index funds
In general, the ramifications of the above is that Index funds are a superior investment option for most investors. If you can’t predict what happens next with any success then why try or expend extra fees on a manager who will try? At best there might be an argument in there that you focus on a specific area of the economy as a long term holding in hopes of hitting that long term. But, remember the long term could be a lifetime.
We are left with one more anecdote. At present, Warren Buffet has a running bet against 5 hedge fund managers that index funds will beat hedge funds over a 10 year period. Warren is winning that bet handily with the index funds up 60 some percent to just below 30 percent for the hedge funds. Perhaps, you should consider his actions as advice. When combined with avoidable investment expense fees, the hedge funds and active investments look even worse. The choice is yours.
How do you invest?