Message Font: Serif | Sans-Serif
No. of Recommendations: 13
This is something that is key to the very definition of value investing.

Do you believe that the market is efficient? Every day and in every way, all the time, no exceptions?

If so, I humbly submit that you should index. Do not even give it a second thought, pick an index, any index and go for it. Drip into it, dca into it, funnel money directly into it via IV push, feed it like you would your pet puppy. You will come out a winner in the end. After all, you can not lose - markets are efficient.

However, I would also humbly submit that that is not value investing.

No, no, no. Value investing is about finding good stocks at good prices. Value investors do not believe that the market is efficient all the time, and they don't believe in paying extravagant prices for securities. So, what they do is they carefully scrutinize a company before they decide to buy it, and then they patiently wait for the desired security to "go on sale," or come into a price range that represents a reasonable value.

If I am wrong on any of this, please let me know.

To say that value investors, "exploit inefficiencies of the market," does sound a little harsh on first hearing it, but it is, in fact, what we do. Is it not? Value investors have a ball in a bear market and I believe it is these investors that usually determine the bottom of any bear market. Because there comes a point where any given security reaches a price that represents an irresistable value to some investor somewhere. And when others see what a deal he got, they jump right in after him. Then the momemtum guys jump on and boom, we find ourselves in a bull market again. Value investors usually have a harder time finding true value in a bull market.

An index investor is the exact opposite of a value investor. A mechanical investor is also the exact opposite of a value investor. An index investor is, in fact, a mechanical investor. They buy stocks at any price, for reasons that completely and purposefully overlook the underlying value.

The biggest irony to all of this is:

The whole basis for the Efficient Market Theory in the first place is that every investor will carefully scrutinize his chosen investments before he purchases them. It is by the very act of each individual "valuing" a stock, and in essence putting a certain price on it and then forming an overall consensus that forms the "efficient" market price (according to the theory). EMT says, "the information is priced in."


As more and more investors buy stocks without carefully examining them (indexing, mechanical, momentum, whatever)... what happens? The market is no longer efficient, prices are being set arbitrarily by uninformed investors. The "information" is not "priced in" ... the information was discarded, thrown out the window, and labeled irrelevant.

How ironic is that? It's beautiful. For indexing to truly work, markets must be efficient, but as soon as even one person begins indexing, efficiency declines and is eventually lost altogether.

Why is that?

Because companies do not grow at the same rate. They do not improve margins at the same rate, or increase profits, or encounter difficulties at the same rate. Thus simply throwing money at a group of companies at the same rate is conceptually absurd. Who would do that? Yet, many, many people are doing just that because they think that markets are efficient, and the odds are in their favor, and indexing is the market, and everyone else is doing it, and it's easy, and you always get market returns, and ... ad nauseum.

The stock market has become something it was never intended to be.

Here is a really good article about how indexing and other programs are changing the markets.

Here's some excerts:
Incredibly, as the index performs even better versus active management because more money is thrown at it, still MORE money is thrown at it. Indexing becomes a cycle of moronic simplicity.
Thus far in 2003, programs account for about 546 million shares per day, about as much as total NYSE volume ran in 1997! Growth in Program Trading has been exploding. Our concern with programs is that we cannot pin any vestige of sentiment on their implementation. Transactional velocity in the market that is driven without sentiment or the benefit of the fundamental analysis of individual companies - like indexing - destroys the pricing efficiency of individual shares. As you can clearly see, Programs now comprise 41% of NYSE volume. Is the small investor important anymore?

Programs now comprise 41% of NYSE volume To me that says that markets, at least the NYSE, is at least 41% inefficient at the current time. How is this inefficiency going to affect index investors going forward? I presume it will substantially lower the overall returns eventually, and thus another "strategy" once overused will no longer work. I look forward to the day that happens so the market will slow down a little and stop with the extreme rushes of ups and downs we've seen in recent years. Until then, I'm sure it's a roller coaster ride for all of us.


ps. sorry for this getting a little bit too much like a rant. I just thought that the index approach would not have any place on a board named for value investing.

pps. I can go away now. I'm sorry for interupting.
Print the post  


What was Your Dumbest Investment?
Share it with us -- and learn from others' stories of flubs.
When Life Gives You Lemons
We all have had hardships and made poor decisions. The important thing is how we respond and grow. Read the story of a Fool who started from nothing, and looks to gain everything.
Contact Us
Contact Customer Service and other Fool departments here.
Work for Fools?
Winner of the Washingtonian great places to work, and Glassdoor #1 Company to Work For 2015! Have access to all of TMF's online and email products for FREE, and be paid for your contributions to TMF! Click the link and start your Fool career.