Has Index Fund Growth Impaired Markets?
One concern about the increasing popularity of index funds is whether the decline in active management has impacted the function of markets.
When it comes to investing (or anything in life worth doing well), it helps to know what you are facing. In this case, that is “the market.” How do you achieve every investor’s dream of buying low and selling high amidst a crowd of highly resourceful and competitive players? The answer is to play with and not against market forces by understanding how market pricing occurs.
Technically, “the market” is a plural, not a singular, place. There are markets for trading stocks, bonds, commodities, real estate and more in the U.S. and worldwide. For now, you can think of these markets in aggregate as a single place, where participants from all around the globe compete against one another to buy low and sell high.
Granted, this “single place” is enormous. It represents a huge number of participants who are individually AND collectively helping to set fair prices every day. That is where things get interesting.
Before the academic evidence showed us otherwise, it was commonly assumed that the best way to make money in seemingly ungoverned markets was through a “lone wolf” approach known as traditional active investing.
To succeed, a traditional active investor seeks to become an expert at forecasting market pricing so they can successfully pick stocks (pick/avoid future winning/losing stocks), and/or time the market (enter/exit ahead of rising/falling markets). In so doing, their goal is to earn higher returns than markets are expected to deliver “passively” to anyone who is participating in them.
Unfortunately, this outdated active approach to beating the market is inherently flawed. A simple jar of jelly beans shows us why. Academia has revealed that the market is not so ungoverned after all. Yes, it is chaotic when viewed up close. But it is also subject to a number of important larger forces.
One of these is group intelligence. The term refers to the notion that, at least on questions of fact, groups are better at consistently arriving at accurate answers than even the smartest individuals in that same group, with a caveat: Each participant must be free to think independently, as is the case in free markets. (Otherwise, peer pressure can taint the results.)
In his landmark book, “The Wisdom of Crowds,” James Surowiecki presented and popularized an enormous body of academic insights on group intelligence.
Take those jelly beans, for example. In one college experiment, 56 students guessed how many jelly beans were in a jar that held 850 beans. The group’s aggregated average guess came relatively close at 871. Only one student in the class guessed closer than that. Similarly structured experiments have been repeated under various conditions. Time and again, the group consensus was among the most reliable counts.
Now apply group wisdom to the market’s multitude of daily trades. Each trade may be spot on or wildly off from a “fair” price, but the aggregate average incorporates all known information contributed by the intelligent, the ignorant, the lucky and the lackluster. These current prices set by the market are expected to yield the closest estimate for guiding the market’s next trades. It is not perfect, mind you, but it is the most reliable estimate in an imperfect world.
Understanding group intelligence and how it governs efficient market pricing is a first step in more consistently buying low and selling high in competitive markets. Instead of believing the discredited notion that you can actively outguess the market’s collective wisdom, you are better off concluding that the market is incredibly efficient at its price-setting job. Your job then becomes efficiently capturing the returns that are being delivered.
But that is a subject for future Evidence Based Investment Insights. Next up, we will explore what causes prices to change. Chances are, it is not what you think.
This post was written and first distributed by Wendy J. Cook.
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