Stock markets are one of my favorite things to look at from a “wisdom of crowds vs. uniquely qualified minds” perspective. Over the last few decades the school of thought that supports the “efficient market hypothesis” (EMH) – all known news is accurately reflected in current stock prices, thus there is no way for active investors to do better without basically cheating – has increasingly gained steam. In turn, the advice being given to many people is that they should forget about things like actively managed mutual funds, buy a bunch of index funds and ETFs instead, and they will end up better off.
But what’s interesting here is that while the suggestion makes perfect sense from an individual perspective based on historical data, the more and more people that accept the rational EMH theory actually introduces an extraordinary amount of irrationality into the market, which naturally leads to these same people invalidating the EMH theory due to the support they are giving it, and active investment strategies making sense again. So by being “right”, it makes itself wrong. Let me try to explain this apparent contradiction.
Why the argument made sense historically was that “active” investors and mutual funds made up the majority of funds in the market. Their collective decisions were what drove stock prices, but each individual actor in the market was taking a (often high) commission for their work. In turn, if all the money in the markets was being invested “actively”, it was a mathematical certainty that the overall returns for ALL those investors would sum to whatever the market gained, less the commissions. And over time, as history has revealed and makes perfect sense, something like 90% of active mutual funds ended up under performing the market, at a rate roughly equal to the fees and commissions collected if you look at them on aggregate. There was no other possible outcome.
Ergo, the advice is to just buy index funds. But here’s the rub. The other maxim of investing, as my colleague Ian Da Silva constantly reminds me, is to “buy low, sell high”. That’s certainty how active investors try to make money, and absolutely no one would argue that “buy high, sell low” is a good investment strategy. But index funds, as they are set up, tend to do just that.
The reason is that most index funds are weighted to one index or another (S&P 500, TSE, etc.), and they regularly adjust their holdings to reflect those indexes. While the complexities of market weighting versus float weighting and all the rest is too much to get into here (though market weighting makes for the simplest explanation of what I’m talking about – wikipedia provides a fine overview), as a general rule companies that are doing well increase in importance in the index, and those that are doing poorly decrease in importance or are removed all together. And well is generally reflected in the stock price.
So see what I mean by “buy high, sell low”? If a company starts doing well, the price likely is trending up, and as an index investor you’ll generally be buying more; if it starts doing poorly, the price drops, and you will be selling. So over and over again, you are buying what is going up, and selling what is going down. Buy high, and sell low – an approach that makes perfect sense and no sense at all, at the same time.
To make the point further, jump to the extreme case – 100% of investors are index investors at a fixed moment in time. A company starts doing better, and for one reason or another gets an increased weighting in a given index. Every single one of us then starts buying more, simultaneously, driving the price up, and up, and up. In the short-term this is a lovely self-fulfilling prophecy of “wealth building” for everyone, with the rise of Nortel back in the day as a great example. But in the long-term, it’s likely a disaster – with Nortel as a great example again. To me, that looks like a very inefficient, pyramid scheme-like approach – and I’m becoming increasingly convinced that is what is driving a lot of market activity today.
So where I’m going with this is simple – as more and more individuals are taking passive investment approaches, and more and more massive pension funds are doing the same, they are doing so because of the belief in the efficient market hypothesis, based on past historical results. But with this many people doing it at once, it is my belief that they are introducing a massive inefficiency into the market – and in turn opening up huge opportunities for active investors to make money.
That is, of course, if you are a good active investor – of which there are relatively few. I personally manage all my own investments and hope I’m one of the good ones, but only time will tell whether this leads me to living in a cardboard box or not. But for individuals that might believe in this underlying argument but are not quite willing to go it alone, the time might be right to try to find the next Warren Buffett (or perhaps just invest in his fund directly) instead of buying the index, because all of these people acting as if markets are efficient are likely messing them up – and creating great opportunities for him or her.
That is unless too many people do it at once – then you should go back to index investing again 
. Underlying it all is one saying that I think will always hold true – “if you want to get rich, the best approach is to figure out what everyone else is doing, and do the opposite.”
