Basic Efficient Market Theory Q

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collinser
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Basic Efficient Market Theory Q

Post by collinser » Fri Mar 07, 2014 3:07 pm

As has been recently mentioned on this forum, being an index investor is simple, but not easy. To be successful, you've got to be able to be convinced that the market is at least reasonably efficient (i.e. active opportunities exist only for short periods of time and then the market corrects to remove them. See Random Walk on Wall Street, etc.)

My observation (and my own experience) is that a significant number of equity buy/sell decisions have nothing to do with price. I buy and hold index funds through my entire accumulation phase and sell throughout my entire retirement phase. I buy according to my investment goals and asset allocation, but with no attempt to buy low or sell high. I read that Vanguard has changed the investment marketplace, not only becoming more and more popular, but also forcing other brokerages like Fidelity to offer competitive low-cost index options as well.

According to a Boglehead philosophy, we do not buy and sell based on price (or any market metric) only rebalance and maybe glide asset allocation over time. If applied in sufficient numbers, aren't these principals in conflict with an efficient market? Could widespread Bolgeheading potentially increase equity prices, for example, by simply blindly creating demand? Or is the slice of the market following a disciplined approach like this so small that it's effects are simply swallowed up in the bigger market?

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dratkinson
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Re: Basic Efficient Market Theory Q

Post by dratkinson » Fri Mar 07, 2014 4:20 pm

collinser wrote:...
According to a Boglehead philosophy, (1) we do not buy and sell based on price (or any market metric) only rebalance and maybe glide asset allocation over time. If applied in sufficient numbers, aren't these principals in conflict with an efficient market? (2) Could widespread Bolgeheading potentially increase equity prices, for example, by simply blindly creating demand? (3) Or is the slice of the market following a disciplined approach like this so small that it's effects are simply swallowed up in the bigger market?
I'm a novice investor, but will take a swing from remembered past topics. Senior investors will correct to 100%.

(1) No. Our actions only affect our personally-chosen risk exposure to the market.

(2) No. Buying at the market price does not change the market price. It is active investors who move the market price by buying/selling---bidding the price up/down.

(3) No. It only requires a few active investors to set the market price, so there is lots of room for indexers.
d.r.a, not dr.a. | I'm a novice investor, you are forewarned.

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DonCamillo
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Re: Basic Efficient Market Theory Q

Post by DonCamillo » Fri Mar 07, 2014 4:57 pm

More cash added to the market drives up market prices. That is one reason Wall Street has sometimes advocated privatizing Social Security. (Think of all the commissions on that extra money! Think how much Wall Street made on 401ks!)

But, if more money is available for investment, theoretically new companies would come along to invest in. Ideas and businesses that could not be funded if capital is scarce will be funded when capital is plentiful. So the market will adjust.

The other part of your question is that blindly investing in the index would raise all the prices equally. So for example, if the total market is worth $10 trillion and index investors invest an extra $5 trillion, that should make every stock increase exactly 50%. The reason that does not happen is that prices are set at the margin. If we index investors are just holding on to our stocks, it is the people who sell or buy specific stocks that determine the relative prices of the stocks.
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Re: Basic Efficient Market Theory Q

Post by steve_14 » Fri Mar 07, 2014 5:10 pm

You mean is the market ever going to start leaving a billion or even a million dollars on the table? No.

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ogd
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Re: Basic Efficient Market Theory Q

Post by ogd » Fri Mar 07, 2014 6:06 pm

Is it just me or is this question being asked a lot lately? Is there a prominent article or perhaps a new financial industry slogan?

Anyway, here are my answers:
http://www.bogleheads.org/forum/viewtop ... 9#p1985778
http://www.bogleheads.org/forum/viewtop ... 0#p1967538
http://www.bogleheads.org/forum/viewtop ... 6#p1898667

Leeraar
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Re: Basic Efficient Market Theory Q

Post by Leeraar » Fri Mar 07, 2014 6:53 pm

It's a common mantra: If everyone indexed, the market would be inefficient, and the indexers would be losers.

Except, there would then be dollar bills on the sidewalk for those very smart non-indexers to pick up, and the market would become more efficient ...

Nothing to worry about.

By the way did you know that indexers are also parasites, profiting on the backs of those who take risks to make markets efficient?

L.
You can get what you want, or you can just get old. (Billy Joel, "Vienna")

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Phineas J. Whoopee
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Re: Basic Efficient Market Theory Q

Post by Phineas J. Whoopee » Fri Mar 07, 2014 9:00 pm

Leeraar wrote:...
By the way did you know that indexers are also parasites, profiting on the backs of those who take risks to make markets efficient?
...
I'm pretty sure that's what motivated Lenin, Trotsky, and Stalin to act against those dastardly kulaks. *

* Intending no personal offense, of course, toward poster kulak.

PJW

rkhusky
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Re: Basic Efficient Market Theory Q

Post by rkhusky » Fri Mar 07, 2014 9:26 pm

Not everyone uses the same indexes. Most tilters here use indexes to perform their tilt. Perhaps if everyone tllted to small value, that might affect the markets.

claver
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Re: Basic Efficient Market Theory Q

Post by claver » Fri Mar 07, 2014 9:41 pm

collinser wrote:As has been recently mentioned on this forum, being an index investor is simple, but not easy. To be successful, you've got to be able to be convinced that the market is at least reasonably efficient (i.e. active opportunities exist only for short periods of time and then the market corrects to remove them. See Random Walk on Wall Street, etc.)

My observation (and my own experience) is that a significant number of equity buy/sell decisions have nothing to do with price. I buy and hold index funds through my entire accumulation phase and sell throughout my entire retirement phase. I buy according to my investment goals and asset allocation, but with no attempt to buy low or sell high. I read that Vanguard has changed the investment marketplace, not only becoming more and more popular, but also forcing other brokerages like Fidelity to offer competitive low-cost index options as well.

According to a Boglehead philosophy, we do not buy and sell based on price (or any market metric) only rebalance and maybe glide asset allocation over time. If applied in sufficient numbers, aren't these principals in conflict with an efficient market? Could widespread Bolgeheading potentially increase equity prices, for example, by simply blindly creating demand? Or is the slice of the market following a disciplined approach like this so small that it's effects are simply swallowed up in the bigger market?
Actually, I think you are quite right theoretically and that index investors are a source of noise in an efficient market because they are buying and (during retirement) selling stocks and thereby affecting the pricing of stocks without using any information related to the value of the individual stocks they are buying and selling. They therefore do not participate in setting efficient prices. It is as if someone bought real estate without looking at the value of what they were buying but simply purchased a house at the going price in every zip code. This would distort the setting of efficient prices for houses, and so it should also for stocks. I guess the question is how large the noise effect gets to be. Indexing has become more and more widespread, and that would contribute to increased noise. As indexing continues to expand, so will the noise.

terrabiped
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Re: Basic Efficient Market Theory Q

Post by terrabiped » Fri Mar 07, 2014 11:31 pm

collinser wrote:If applied in sufficient numbers, aren't these principals in conflict with an efficient market? Could widespread Bolgeheading potentially increase equity prices, for example, by simply blindly creating demand? Or is the slice of the market following a disciplined approach like this so small that it's effects are simply swallowed up in the bigger market?
I don't know what you mean by in conflict with an efficient market. But I believe it is true that when sufficient numbers of people keep pouring money into equities, the market keeps going up. And when this phenomena gets out of hand, some of us call it irrational exuberance. I don't know what EMH calls it.

That said, this type of bubbly price appreciation isn't about index funds. Investors can create the same effect investing in active funds or individual stocks. It doesn't really matter how investors keep pouring money into equities, only that they do. Think of past housing bubbles. What caused those? There are no index funds for buying houses.

claver
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Re: Basic Efficient Market Theory Q

Post by claver » Fri Mar 07, 2014 11:55 pm

claver wrote:
collinser wrote:As has been recently mentioned on this forum, being an index investor is simple, but not easy. To be successful, you've got to be able to be convinced that the market is at least reasonably efficient (i.e. active opportunities exist only for short periods of time and then the market corrects to remove them. See Random Walk on Wall Street, etc.)

My observation (and my own experience) is that a significant number of equity buy/sell decisions have nothing to do with price. I buy and hold index funds through my entire accumulation phase and sell throughout my entire retirement phase. I buy according to my investment goals and asset allocation, but with no attempt to buy low or sell high. I read that Vanguard has changed the investment marketplace, not only becoming more and more popular, but also forcing other brokerages like Fidelity to offer competitive low-cost index options as well.

According to a Boglehead philosophy, we do not buy and sell based on price (or any market metric) only rebalance and maybe glide asset allocation over time. If applied in sufficient numbers, aren't these principals in conflict with an efficient market? Could widespread Bolgeheading potentially increase equity prices, for example, by simply blindly creating demand? Or is the slice of the market following a disciplined approach like this so small that it's effects are simply swallowed up in the bigger market?
Actually, I think you are quite right theoretically and that index investors are a source of noise in an efficient market because they are buying and (during retirement) selling stocks and thereby affecting the pricing of stocks without using any information related to the value of the individual stocks they are buying and selling. They therefore do not participate in setting efficient prices. It is as if someone bought real estate without looking at the value of what they were buying but simply purchased a house at the going price in every zip code. This would distort the setting of efficient prices for houses, and so it should also for stocks. I guess the question is how large the noise effect gets to be. Indexing has become more and more widespread, and that would contribute to increased noise. As indexing continues to expand, so will the noise.
On thinking about this a bit more, it seems as though indexing, since it buys "all" of the stocks in a broad swath of the market, would raise the prices of all the stocks in the swath of the market that it buys without affecting their valuations relative to each other, which would remain the province of efficiency-promoting individual pricing decisions. So, would indexing then constitute noise in an otherwise efficient market or would it simply be raising (or lowering, during retirement) the base price of everything?

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ogd
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Re: Basic Efficient Market Theory Q

Post by ogd » Sat Mar 08, 2014 12:11 pm

claver wrote:On thinking about this a bit more, it seems as though indexing, since it buys "all" of the stocks in a broad swath of the market, would raise the prices of all the stocks in the swath of the market that it buys without affecting their valuations relative to each other, which would remain the province of efficiency-promoting individual pricing decisions. So, would indexing then constitute noise in an otherwise efficient market or would it simply be raising (or lowering, during retirement) the base price of everything?
Yes, indexing should not affect the relative valuations, which is part of the point: if you move with the flow, you have far less friction, which is seen in the extremely low turnover rates. Indexers do not "fight" market prices. There are other effects at work:
1) "Tilted" indexing, e.g. preferring small caps, will affect the valuations of that end of the spectrum. Such investors are okay with being sort-of-active and should live with this effect (which they believe insignificant compared to the value they are getting).
2) Moving in and out of stocks altogether, what you call "noise": to the extent that it isn't active timing, this is a demographic effect (net delta between accumulating / retiring), but actually independent of indexing. Such investors would do the same with active stock funds.
3) Indexing results in less research. Since I believe that too much money and brainpower is spent on this redundant activity between competing firms, by an order or so of magnitude, I am perfectly okay with this.

Leeraar
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Re: Basic Efficient Market Theory Q

Post by Leeraar » Sat Mar 08, 2014 1:25 pm

Watch Larry's video. Mel published a link a few hours ago (last night).

The market gets the market return. The indexers as a group get the market return. By subtraction, everyone else then also gets the market return. Less expenses.

If the market has anomalies the active non-indexers will fix them and those parasites, the passive indexers, will benefit.

Actually, as Jack Bogle likes to point out, it's not that the markets are efficient. Its that passive investors have lower costs.

L.
You can get what you want, or you can just get old. (Billy Joel, "Vienna")

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Phineas J. Whoopee
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Re: Basic Efficient Market Theory Q

Post by Phineas J. Whoopee » Sat Mar 08, 2014 3:43 pm

Leeraar wrote:...
If the market has anomalies the active non-indexers will fix them and those parasites, the passive indexers, will benefit.
...
If the anomalies are between stocks in general and other assets in general, the parasitic non-risk-taking takers suffer just as much as the hardworking and daring makers (what was it the active investors were making again? Oh, yes, I remember: mistakes).

If the anomalies are the relative prices within the stock market the blood-sucking leeches will be indifferent, because they're on every side of every trade. It's simply irrelevant to them. Darn those sluggish derelicts!
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It is ours, not to slave in, but to master and to own.
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Leeraar
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Re: Basic Efficient Market Theory Q

Post by Leeraar » Sat Mar 08, 2014 3:49 pm

PJW,

Yes, but the active investors are paying higher costs while you, sir, are a freeloading hitch-hiker.

L.
You can get what you want, or you can just get old. (Billy Joel, "Vienna")

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Phineas J. Whoopee
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Re: Basic Efficient Market Theory Q

Post by Phineas J. Whoopee » Sat Mar 08, 2014 4:00 pm

Leeraar wrote:PJW,

Yes, but the active investors are paying higher costs while you, sir, are a freeloading hitch-hiker.

L.
While at the same time I offload to them my fair share of the cost of running the place, by engaging in fewer taxable transactions. If I were a captive adviser securities analyst personal finance counselor stockbroker financial services salesperson I'd speak ill of me too.
PJW

KyleAAA
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Re: Basic Efficient Market Theory Q

Post by KyleAAA » Sat Mar 08, 2014 4:06 pm

This topic has been discussed ad infinitum on this site. You can probably satisfy your curiosity using the search feature.

Professor Emeritus
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Re: Basic Efficient Market Theory Q

Post by Professor Emeritus » Sat Mar 08, 2014 4:52 pm

KyleAAA wrote:This topic has been discussed ad infinitum on this site. You can probably satisfy your curiosity using the search feature.
+1 And do recall it is the Efficient Market Hypothesis . It generates good testable hypotheses, but it is by no means a "theory" as that word is properly used.

kontango
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Re: Basic Efficient Market Theory Q

Post by kontango » Sat Mar 08, 2014 9:31 pm

I'll quibble with your first point that indexing requires one to believe that markets are reasonably efficient. Market efficiency is sufficient for lack of predictability in prices, but it's not necessary. Even if we're all irrational (i.e., subject to behavioral biases), our behavioral biases can't be aggregated easily and therefore do not necessarily lead to predictable markets.

In other words, both market efficiency and behavioral finance adherents believe, for the most part, that markets are difficult to predict consistently. They just disagree as to what drives the unpredictability.

Leeraar
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Re: Basic Efficient Market Theory Q

Post by Leeraar » Sat Mar 08, 2014 11:00 pm

kontango wrote:I'll quibble with your first point that indexing requires one to believe that markets are reasonably efficient. Market efficiency is sufficient for lack of predictability in prices, but it's not necessary. Even if we're all irrational (i.e., subject to behavioral biases), our behavioral biases can't be aggregated easily and therefore do not necessarily lead to predictable markets.

In other words, both market efficiency and behavioral finance adherents believe, for the most part, that markets are difficult to predict consistently. They just disagree as to what drives the unpredictability.
I think that indexing is simply about choosing your level of risk. Choose your poison.

Investing in the total market is then about diversification, and lowering risk.

Then, the BH argument is that costs matter. That's all.

The efficient market is really about your ability to get an advantage when every one else knows what you know. You cannot.

If you index the total market, what does it matter that markets are efficient or not? The efficient market hypothesis is only there to convince you that "you don't know nothing". It is not a precondition for the superiority of passive investing, which rests on lower costs.

L.
You can get what you want, or you can just get old. (Billy Joel, "Vienna")

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Re: Basic Efficient Market Theory Q

Post by MapleHermit » Sat Mar 08, 2014 11:34 pm

If everyone became a Boglehead, the market would still be relatively efficient and beat active managers. However, if people over invest in large cap stocks ONLY, large cap stocks will obviously be overvalued and alternatives such as mid cap and small cap would be slightly more attractive.

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Re: Basic Efficient Market Theory Q

Post by docneil88 » Sun Mar 09, 2014 1:24 am

claver wrote:Actually, I think you are quite right theoretically and that index investors are a source of noise in an efficient market because they are buying and (during retirement) selling stocks and thereby affecting the pricing of stocks without using any information related to the value of the individual stocks they are buying and selling. They therefore do not participate in setting efficient prices.
There are many index fund investors who are also market timers, e.g. my cousin Bill and Bob Brinker, radio personality and investment newsletter writer. Of course, none of them hangs out at bogleheads.org :P

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LH
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Re: Basic Efficient Market Theory Q

Post by LH » Sun Mar 09, 2014 4:25 am

collinser wrote:As has been recently mentioned on this forum, being an index investor is simple, but not easy. To be successful, you've got to be able to be convinced that the market is at least reasonably efficient (i.e. active opportunities exist only for short periods of time and then the market corrects to remove them. See Random Walk on Wall Street, etc.)

My observation (and my own experience) is that a significant number of equity buy/sell decisions have nothing to do with price. I buy and hold index funds through my entire accumulation phase and sell throughout my entire retirement phase. I buy according to my investment goals and asset allocation, but with no attempt to buy low or sell high. I read that Vanguard has changed the investment marketplace, not only becoming more and more popular, but also forcing other brokerages like Fidelity to offer competitive low-cost index options as well.

According to a Boglehead philosophy, we do not buy and sell based on price (or any market metric) only rebalance and maybe glide asset allocation over time. If applied in sufficient numbers, aren't these principals in conflict with an efficient market? Could widespread Bolgeheading potentially increase equity prices, for example, by simply blindly creating demand? Or is the slice of the market following a disciplined approach like this so small that it's effects are simply swallowed up in the bigger market?
Well, I follow you. I do not neccessary disagree per se. But in some sense, I do:

We are de facto, buying the asset that has dropped the most in price since the last rebalancing, relative to the other asset classes. We rebalance based on price.

This is buying low, and selling high, in a relative sense, within our portfolios.

It does not mean we will come out ahead though, since it is not the same thing we are buying.

For instance, take just 50/50 stocks bonds. We will on average expectantly, sell stocks, buy bonds, but since expectantly, stocks will do better than bonds, we will come out losers versus no rebalancing.

Now if the classes expectantly make the same, and there is low correlation, then rebalancing comes out a winner.

kontango
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Re: Basic Efficient Market Theory Q

Post by kontango » Sun Mar 09, 2014 9:39 am

Leeraar wrote:
kontango wrote:I'll quibble with your first point that indexing requires one to believe that markets are reasonably efficient. Market efficiency is sufficient for lack of predictability in prices, but it's not necessary. Even if we're all irrational (i.e., subject to behavioral biases), our behavioral biases can't be aggregated easily and therefore do not necessarily lead to predictable markets.

In other words, both market efficiency and behavioral finance adherents believe, for the most part, that markets are difficult to predict consistently. They just disagree as to what drives the unpredictability.
I think that indexing is simply about choosing your level of risk. Choose your poison.

Investing in the total market is then about diversification, and lowering risk.

Then, the BH argument is that costs matter. That's all.

The efficient market is really about your ability to get an advantage when every one else knows what you know. You cannot.

If you index the total market, what does it matter that markets are efficient or not? The efficient market hypothesis is only there to convince you that "you don't know nothing". It is not a precondition for the superiority of passive investing, which rests on lower costs.

L.
I agree that the beauty of indexing rests on low costs, but only because markets are largely unpredictable. If markets were predictable and active managers could use that predictability to earn positive alpha (net of fees), then we would gladly pay the higher fees to get their expertise. There would be no reason to index.

My point is that we don't necessarily have to believe in market efficiency for indexing to be a good strategy, since markets don't have to be efficient to be unpredictable. It's a minor point, but I bring it up because "market efficiency" is such an emotionally loaded term these days with professional money managers and many financial advisors and we don't have to invoke it to conclude that markets are largely unpredictable and indexing is a good strategy.

Cheers!

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