I was wondering whether this was worth blogging on again, but Richard Beddard made up my mind with his attack on the efficent markets hypothesis, and his defence of active investing.
I am not going to argue about whether markets are efficient or not as it gets bogged down in definitions. No one thinks that markets never misprice (bubbles defintely happen). On the other hand it is clear that there is some reason to how markets price securities most of the time.
The real problem for that active investors lose regardless of whether markets are efficient or not.
The argument is simple and mathematically inescapable (and one I have made before). Passive investors perform in line with the market, therefore the part of the market not held by them most also perform in line with them. This must be held by active investors, therefore, active investors must, in aggregate, perform in line with the market.
To put it another way, one active investor can only gain (out-perform) if another loses. Active investing is a zero-sum game.
Actually, it is even worse than that. active investing is more expensive, so, net of costs, active investors under-perform. As put in the most lucid explanation of the problem I have read, it is a negative sum game.
Comments
RichardHi Graeme. I get a feeling of deja vue. I agree, and thanks for the link, it's fascinating. Even though it's a zero-sum-game (probably negative after costs), I do think it's a game individual investors can win, because the market isn't efficient :-)
Michael GreenThe flaw in the efficient market hypothesis is still its assumption that win and lose mean the same thing to all the participants. If different participants have different objectives, then the market is a hybrid, and everyone can win.
As a pensioner, I want to preserve capital with an income that rises with inflation. I don't want to live like a pauper and die a millionaire. I don't care if other investors think they have beaten me.
A pension fund should invest with a time horizon that is of no interest to the average speculator (though trying to persuade pension fund trustees and advisors to think this way is an uphill struggle.) The long term is generally only invoked to promote investments that are dubious on any other basis.
[...] says active investing is a negative-sum game. So do Eugene Fama and Kenneth [...]
MonevatorPeople don't engage in active investing because they believe active investors will win. Not if they've read around a bit anyway. They do it because they believe they will be one of the winners that balances out the losers. If it's a zero sum (ex cost) game, then it's human nature to think you'll be one of the winners.
Knock it if you like, but that spirit gave us fire, the wheel, the four-minute mile and, erm, Britain's Got Talent.
I try to moderate the beast by focusing on passive investments and tinkering with a portion in stock picked shares. I accept I'll probably lose, but at least there's the possibility of feeling like a winner.
Moneyterms Blog > How and you can beat the market part one: irrationality[...] promised (on both a comment on Interactive Investor and an earlier post here) to explain why I think it is possible to identify areas of market — or how to tell when [...]