In May, 1896, Charles Dow and Edward Jones put their heads together and created the Dow Jones Industrial Average. A stock market index comprised of twelve industrial stocks, this scion of indexes was first published on the 26th day of that month and “The Dow” was born.
Charles Dow, editor of The Wall Street Journal at the time, could now give his readers an easy to reference sense of how the stock market performed.
Essentially, they made a ruler for the stock market.
In 1923, Standard & Poor’s created its own index of a small number of stocks. By 1957 they had expanded the index to include five hundred stocks — giving us the S&P 500 we know today.
Now, Messrs. Dow and Jones were not suggesting their readers buy all twelve stocks in their index and call it a day. Standard & Poor’s was not making an investment recommendation to own all the stocks in their index.
Their indexes were stock market rulers. When a carpenter holds a ruler against the wall, does he drive a nail every 16th of an inch simply because there are marks every 16th of an inch?
Why, then, does it make sense to look at a ruler designed to measure the stock market and buy every stock in the ruler?
The Genesis of Passive Investing
Buying every stock in an index is referred to as “passive investing.” The rationale supporting the practice comes from the notion that the price of any stock at any point in time reflects all available information about that stock. This is referred to as the Efficient Market Hypothesis, or EMH for short.
This hypothesis suggests that with so many sophisticated investors scrutinizing company financial statements, product demand, management quality and economic conditions as well as corporate insiders buying and selling based on even better information (in a legal way), what chance does a typical investor have of ever knowing more about a company than all other sophisticated market participants?
As the theory goes, regular investors cannot possibly overcome this “informational asymmetry”. Anything that is known is already perfectly reflected in the stock price and any future price action is a surprise. Price changes will be purely random.
So, you’re late to the party and the good wine is gone. You might as well drink the cheap stuff and make the most it.
The Logical Leap
Some take EMH even farther and suggest that no one can consistently garner good information — meaning no one has consistent informational asymmetry — so it is impossible to do better than the stock markets ruler. No one can beat the index.
This last leap poses the biggest problem. If no investor consistently has an edge and is, therefore, not getting prices to perfection in the first place then no investor consistently gets it wrong. Furthermore, those that get it right perfectly balance those that get it wrong at all points in time. If no one either loses or wins consistently then everyone’s performance should ultimately match the index.
Impossible logic.
Moreover, to defend this last leap in logic is to ignore the long list of successful investors, some you’ve heard of, most you have not, that stand in direct refutation of this absurd conclusion.
Rational Discipline
Setting aside the ultimate absurdity that no investor can beat the market, what is the core assumption upon which the above conclusions of EMH are drawn?
Investors are rational.
These perfectly rational actors objectively assess all information and never pay more for a stock than it is worth.
Fear and greed play no part.
These perfectly rational investors, like Data from Star Trek, are blissfully free from emotion and bias. They do not allow their recent experiences to play a role in how they view a stock. They are not hesitant to sell a stock at a loss. They don’t focus too much on data that confirms why they bought the stock in the first place.
In short, these sophisticated investors are gloriously unbounded by the deeply studied behavioral traps that define the human condition.
In my experience, people (of which sophisticated investors are included) are far from consistently rational. Though many professional investors tend to be much better at eliminating biases, are exceptional thinkers and have disciplines upon which they rely, these investors, while more than a mere exception, are far from the rule.
And therein lies the edge for active investors. That the undisciplined far outnumber the highly-disciplined leads to opportunities for the latter.
There are many other issues with passive investing, the most troubling of all being that more passive investors equals more stock market risk.
However, the silver lining is that the more bad investors there are, whether passive or undisciplined, the easier the hunting for those actively, and patiently, paying attention.
