I agree with your ultimate conclusion that indexing is a good way to invest, but I think that you exaggerate the collective wisdom of markets.

"Markets work when they possess 1) multiple agents of diverse and independent opinion, ... All markets, whether for chewing gum on the school playground, for the future delivery of wheat or for the information contained on the Internet, operate under those same three conditions. The greater the number of agents, the more diverse their opinions, the greater the incentive for participation and the more advanced the aggregating mechanism, the better that market will function. The stock market is the consummate example." It's doubtful how "independent" and "diverse" opinions were during the internet bubble, or in any other mania. And there are times when the collective wisdom of the market gets it spectacularly wrong, such as when it decided that SIV securities, since they were AAA-rated, insured, and all that, deserved only a miniscule risk premium. Just as Google doesn't always return the website you are looking for as its top pick, the market is good, but not infalliable.

I agree with you. The market isn't perfect, all of the time. There will certainly be breakdowns in the diversity and independence of market participants at times. We've seen this over the course of history (tulip-mania, "death of equities", tech bubble, etc.), where--with the benefit of hindsight--we've seen the market get it wrong....and we're sure to see them again. If the market were perfectly efficient all the time there would be no incentive for anyone to pick stocks or time the market. No one would profit from efforts at discovering mis-priced investments. It's precisely the collective wisdom of the market, however, that makes the market so efficient (if still imperfect) and difficult to beat long-term. This is even more true after factoring in the frictional costs (trading, taxes, management fees, etc.) of active management. These costs raise the bar even more (I did not specifically address these costs in this paper, but we have addressed them in others (see www.vistacp.com/documents/5ReasonstoIndex.pdf).

Your point that the market isn't "infallible" leads, I think, to the relevant question for investors: "If we know the market isn't perfect all the time, does it pay to engage in investment activities such as stock/fund picking and market timing to try to exploit the market's imperfections?" I think you know, after reading my paper, what my answer would be. Thanks for your comments.

Hi Dougal,

Thanks for your reply. I actually disagree with very little of what you have said, and I agree that trying to outsmart the market is not a profitable undertaking for the vast majority of investors. Where I might disagree slightly is that I think it is often possible to see bubbles as they happen. For instance, REITs had an unsustainable run the past few years, the beneficiaries of a rate of real estate price appreciation that far exceeded the growth in income (how will anyone afford a house if tat continues indefinitely?). I guess my advice for an investor on an asset class that is having a run-up far in excess of historical trends is to think twice about buying it if you don't already own it, and if you do already own it, force yourself to rebalance (maybe even over-rebalance a la Bernstein) sooner rather than later.
Best wishes.

Rebalancing is key. Unfortunately, most investors throw fuel on the fire rather than sell out of (or pare back) a surging asset class. As an example, consider the tech boom: During the first two months of 2000, investors poured more than $50 billion into US equity mutual funds (primarily large cap growth funds) according to the Investment Company Institute. Combined, these two months represented the largest net inflow into US equity funds in history. The "peak" of the tech period was only a month later. Presumably, it was these same investors in late 2002 who yanked over $80 billion from the same funds. That is what we call perverse (perfect reverse) timing. Buying low, selling high it surely is not. The recent real estate environment eerily echoes this 2000-2002 period.

I don't agree that "Over the long run, it seems the world's smartest investors are not beating the market, the market is beating them.". For example, Warren Buffett has achieved a compounded annual gain of 21.1% comparing with 10.8% with S&P 500 dring the past 42 years (1965 - 2007). I would agree,however, that MOST "smart investors" can not beat the market. The question is how to find the next Warren Buffett.

Good luck with that!!!

What about Warren Buffet? Was he too "Fooled By Chance" for all these decades of investing?

Vlad, "Fooled by Chance" refers to those who buy funds (or invest with a manager) based on that fund's relatively short-term track record of "outperformance." Is the outperformance due to skill or luck? It is exceedingly hard to tell. Studies which have looked at the future peformance of those past "outperformers" suggest it may be more luck than skill. Fewer past winners repeat than would be expected by chance.

In an investment world where costs do not exist, we would expect half of investors dollars' to outperform the market and the other half to underperform, with the market delivering the "average" or market return. In reality, costs exist...which skew the distribution of returns hwereby more investors/managers underperform. The market return becomes akin to "par" in golf--not average in the typical sense.

Certainly, a few star managers will outperform in whatever time period examined...but it's not the same ones period after period.

As for Buffet, he says time and time again most of us should buy a low cost, tax efficient index fund rather than waste the time, energy, and costs (not to mention the risks of being wrong!!) associated with trying to find the needle in the haystack.

Jazz, someone recently said, "if you wake up in the morning and see Warren Buffet in the mirror, pick stocks; if you see anyone else, buy an index fund."

Thanks for your comments,
Dougal