March 01, 2007Indexing and RiskInvestment academics for the last few decades have preached the religion that the only way to win in investing is to diversify away your risk. In other words, they tell everybody to use indexing (and that sort of thing) instead of stockpicking. To me, this seems a little bit defeatist, maybe even intellectually lazy, a way of saying "just put your money where everybody else has already put it." So my question is always, "what happens when everybody indexes their money?" What happens when everybody stops thinking and just starts to mimic the average as closely as they can? In "Ahead of the Tape" in today's WSJ, Justin Lahart muses on the rocky market in the last day or two. And he proposes a hint of an answer to my question:
Once everybody diversifies, is it a surprise when diversification doesn't work as well as it is supposed to? Maybe investments shouldn't go where the money already is. Maybe us investors need to be thinking about where the money will have the biggest future impact. Posted by David at March 1, 2007 08:42 AMComments
That sounds like a promising argument and there's probably some truth to it. However, if stock prices are at least partially based on fundamentals, it seems like unrelated stocks should move independently at least some of the time due to the differing fortunes of the underlying companies. (If they didn't, someone would take advantage of it.) I'm no expert but I think this is a plausible counter-argument: It seems like indexing implies a division of labor between professional stock pickers and investors who just want to let the professionals decide. Instead of hiring a professional and suffering from their limited judgement and conflicts of interest, by using an index, you take advantage of all professional judgements for free. If the quality of the pool of professionals diminished enough, we would be in trouble. But there's no sign of that happening. As amateurs get smart and use indexes, the professionals will have to make their money by trying ever-harder to beat the market and thus making it more efficient, and everyone (hopefully) benefits from that. Note that lots of interesting computer algorithms are already being used by the professionals to make money from tiny discrepancies and it seems pretty plausible that this trend will continue to the point where the computers take over, and competition will be in getting better data into the computers and using better algorithms to take advantage of it. I agree in principle that a smart investor who spends the time to learn about market sectors and wonder about where the money will have the biggest future impact will generate hgher returns than an indexed fund. However, this implies a few things: I always look at the indexing argument as an argument against actively managed mutual funds. Burton Malkiel makes a good argument in "A Random Walk down Wall Street" that Post a comment
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