Passive Investing Makes Even More Sense In Inefficient Mkts

Discuss all general (i.e. non-personal) investing questions and issues, investing news, and theory.
Post Reply
User avatar
Topic Author
nisiprius
Advisory Board
Posts: 52105
Joined: Thu Jul 26, 2007 9:33 am
Location: The terrestrial, globular, planetary hunk of matter, flattened at the poles, is my abode.--O. Henry

Passive Investing Makes Even More Sense In Inefficient Mkts

Post by nisiprius »

Morningstar's Samuel Lee: Why Passive Investing Makes Even More Sense in Inefficient Markets
I like the way he puts it:
In a perfectly efficient market... everyone has the same expected return, before fees, for any given level of risk assumed. The winners are the ones who give up the least amount of market returns to frictional costs. In a perfectly inefficient market, everyone's expected return is purely a function of their skill...

If you're unskilled, you'd rather play in the efficient market.... The situation becomes dangerous if you're unskilled and the market is inefficient. Any deviation from market-cap-weighting is likely to hurt you badly, because someone skilled is going to buy what you're selling and sell what you're buying. In this case, the optimal strategy is to not play the game and passively own the entire market, guaranteeing that you will at least be above-average after fees.

I can think of two reasons why unskilled investors would voluntarily play in an inefficient market: 1) they are delusional, unaware of their own incompetence, or 2) they are willing to lose money for the thrill of playing. Most investors who play do not do so with the expectation of losing, so there must be lots of delusional investors.
But of course there are a lot of delusional investors. Why not? For decades everyone has been feeding their delusions. They have been telling them that skill, enough skill to beat the market, is pretty easy to come by, no harder than learning how to snowboard or cook a pineapple upside-down cake. The advisor in your bank's Funds-R-Us cubicle has it. Any competent fund manager has it. You can get it yourself just by watching Jim Cramer and spending a few hours a week researching five stocks. As a passionate consumer, your expert knowledge of the best hosiery brands will enable you to beat the street by investing in what you know...
Last edited by nisiprius on Tue Feb 10, 2015 8:58 pm, edited 1 time in total.
Annual income twenty pounds, annual expenditure nineteen nineteen and six, result happiness; Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery.
User avatar
seeshells
Posts: 179
Joined: Sun Feb 23, 2014 11:43 am

Re: Passive Investing Makes Even More Sense In Inefficient M

Post by seeshells »

Nisprius, great post!
Last edited by seeshells on Wed Feb 11, 2015 2:10 am, edited 1 time in total.
User avatar
noyopacific
Posts: 359
Joined: Wed Jan 28, 2009 5:06 pm
Location: Mendocino

Re: Passive Investing Makes Even More Sense In Inefficient M

Post by noyopacific »

nisiprius wrote: Morningstar's Samuel Lee:
I can think of two reasons why unskilled investors would voluntarily play in an inefficient market: 1) they are delusional, unaware of their own incompetence, or 2) they are willing to lose money for the thrill of playing. Most investors who play do not do so with the expectation of losing, so there must be lots of delusional investors.
I can think of another:
3) They are aware of their own lack of skill but believe they have the ability to identify a manager with the skill necessary to exploit the market's inefficiencies.
The delusion here is that they believe it is possible to identify who will be a successful manager in the future.
As Morningstar has said:
"If there's anything in the whole world of mutual funds that you can take to the bank, it's that expense ratios help you make a better decision. In every single time period and data point tested, low-cost funds beat high-cost funds."
http://news.morningstar.com/articlenet/ ... ?id=347327
The information contained herein, while not guaranteed by us, has been obtained from from sources which have not in the past proved particularly reliable.
pkcrafter
Posts: 15461
Joined: Sun Mar 04, 2007 11:19 am
Location: CA
Contact:

Re: Passive Investing Makes Even More Sense In Inefficient M

Post by pkcrafter »

Nisiprius wrote:
For decades everyone has been feeding their delusions. They have been telling them that skill, enough skill to beat the market, is pretty easy to come by, no harder than learning how to snowboard or cook a pineapple upside-down cake.
Ah, a stock/bond risk metaphor. :happy

Paul
When times are good, investors tend to forget about risk and focus on opportunity. When times are bad, investors tend to forget about opportunity and focus on risk.
richard
Posts: 7961
Joined: Tue Feb 20, 2007 2:38 pm
Contact:

Re: Passive Investing Makes Even More Sense In Inefficient M

Post by richard »

A classic paper in this genre is The Inefficient Market Argument for Passive Investing, http://marriottschool.net/emp/SRT/passive.html
pkcrafter
Posts: 15461
Joined: Sun Mar 04, 2007 11:19 am
Location: CA
Contact:

Re: Passive Investing Makes Even More Sense In Inefficient M

Post by pkcrafter »

noyopacific wrote:
I can think of another:
3) They are aware of their own lack of skill but believe they have the ability to identify a manager with the skill necessary to exploit the market's inefficiencies.
The delusion here is that they believe it is possible to identify who will be a successful manager in the future.
Here's another clue for the clueless--
We as individual investors are called retail investors and we make up about 26% of the total. The other 74% are institutional investors. Well, we know what retail means--end user paying full retail price.

Institutional investor definition (Wikipedia):
An institutional investor is an investor, such as a bank, insurance company, retirement fund, hedge fund, or mutual fund, that is financially sophisticated and makes large investments, often held in very large portfolios of investments. Because of their sophistication, institutional investors may often participate in private placements of securities, in which certain aspects of the securities laws may be inapplicable.

Institutional investors do this all the time, their success depends on their skills vs those of other institutional investors, plus they don't pay retail price on operating expenses. If a retail investor does not at least show competitive skill, he will quickly be out of the business. That means institutional investors skill level is high, but hey, they are competing with others of equally high skill. Only the bottom quintiles get dumped, the top three quintiles tend to trade positions on the success chart due to some factor other than skill since skill is pretty equal at this level.

A retail investor is bound to lose to these guys if they play the game while paying retail prices demanded by the institutional players. Who do institutional investors make more money off, other institutional investors or retail investors? The only logical way for a retail investors to play is invest in the market created by institutional investors, but don't pay the fees they ask.

Paul
When times are good, investors tend to forget about risk and focus on opportunity. When times are bad, investors tend to forget about opportunity and focus on risk.
garlandwhizzer
Posts: 3562
Joined: Fri Aug 06, 2010 3:42 pm

Re: Passive Investing Makes Even More Sense In Inefficient M

Post by garlandwhizzer »

Very interesting post, nisi, thanks. Perhaps this explains why indexing seems also to work well in areas like EM which are supposed to be inefficient markets. True investment skill is extremely rare in practice, and often, even when present, is either transient (ask Bill Miller and Bill Gross) or pure luck (ask hedge fund giant John Paulson who was right on the real estate crash and has been consistently wrong ever since). In contrast, investing skill is extremely common in fantasy.

Garland Whizzer
uglystickrules
Posts: 85
Joined: Thu Oct 17, 2013 3:14 pm

Re: Passive Investing Makes Even More Sense In Inefficient M

Post by uglystickrules »

Not to tread into economic theory, but efficient markets only exist in models. Any school of economic thought says that just in different ways. For example, Kirzner calls it "market discovery." Stiglitz studies insufficient data and asymmetric information. Inefficient markets spread out the odds of being "right" with any particular market entry with respect to time preference. This tends to head towards what would be the most cost efficient way of entering a market - Coase. Smart investing understands these ideas inherently and therefore leans towards passive methods over the high cost futility of activist investing.
User avatar
JoMoney
Posts: 16260
Joined: Tue Jul 23, 2013 5:31 am

Re: Passive Investing Makes Even More Sense In Inefficient M

Post by JoMoney »

uglystickrules wrote:Not to tread into economic theory, but efficient markets only exist in models. Any school of economic thought says that just in different ways. For example, Kirzner calls it "market discovery." Stiglitz studies insufficient data and asymmetric information. Inefficient markets spread out the odds of being "right" with any particular market entry with respect to time preference. This tends to head towards what would be the most cost efficient way of entering a market - Coase. Smart investing understands these ideas inherently and therefore leans towards passive methods over the high cost futility of activist investing.
Markets are competitive, it's hard to get an advantage (people tend to not just give money away) and once an advantage is found others tend to competitively "arbitrage" away any excess returns. There's not a lot of opportunity to find a "wide moat" or some monopolistic position when comes to securities trading. Big money is spent to get information sooner and to be placed in positional advantages to front-run those in weaker positions, and even those who play that game have a hard time maintaining their advantage and recouping the expenses.

But I don't know that every school of thought implies what the EMH does. The EMH seems to imply that nobody gets these advantages, and that the participants are pricing in "risk premiums" as if there was some standard measure of risk that was consistent across time periods or even broadly amongst different people... and they go off on snipe hunts to find some way to measure risk that is consistent with their initial premise - that any excess return is only had by taking additional risks. When the yard stick they've come up with empirically doesn't work they go back to the drawing board and develop some new model for risk that is supposed to demonstrate the initial premise, when the dirt of the real world piles up on the new model -rinse-wash-repeat...
There are various schools of thought that look for more behavioral models and some that emphasize the dirty work of actually trying to value a business on it's own merits, but as you pointed out above - the conclusions often arrived at is that most investors are best served by broadly diversifying in something like a low-cost index fund, but they don't all necessarily agree with the EMH.
"To achieve satisfactory investment results is easier than most people realize; to achieve superior results is harder than it looks." - Benjamin Graham
Post Reply