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Sunday, July 06, 2003

Passive Investing

This is my first day off work and without overseas visitors in weeks, and I have decided to dedicate a small part of this day to my long-neglected blog. A whle ago I noticed an article by James Glassman on John Allen Paulos's new book A Mathematician Plays the Market. The following passage stood out:

[I]f all investors were convinced that markets were efficient, they would simply sit on their holdings, never buying or selling. In such a world, new information about stocks would never enter the market, moving the prices of stocks in an efficient way.

"The [Efficient Markets Hypothesis] is true," [Paulos] said, "to the extent that people believe it to be false and so, by their exertions, bring about efficiency."

This is a very interesting paradox, and it made me think about mutual funds. Consider the Motley Fool's simple advice, which many consider the best one can give to retail fund investors:

Buy an index fund.

This advice sort-of follows the Efficient Markets Hypothesis: buy a fund that tracks the overall market, for in the long run most actively managed funds can't beat the market. The thing about this is that market performance may depend to some extent on people ignoring this advice. Most of the large players in capital markets are institutional investors like pension and mutual funds. Some of these manage to produce above-market returns through active managment, but most don't, a fact that many retail fund investors are either oblivious to or apathetic about. (A form of rational ignorance perhaps?) The trouble is that the activities of these funds provide the market information that produces "market performance" to begin with.

In the end, all successful passive fund investors owe a debt of thanks to those who are not as "enlightened" as they. Another paradox to think about.