Index Funds Are Not Evidence of Efficient Markets: Why Investor Psychology Matters

I’m loath to disagree with Noah Smith, especially now that he’s soon to be Herr Doktor Professor, but in a very good post, he writes this about efficient markets (boldface mine):

Do we, in fact, see this? I am not sure we do. On one hand, index funds are becoming more popular, signifying greater public acceptance of the Efficient Markets Hypothesis. On the other hand, the recent recession probably decreased faith in rational-expectations models of the macroeconomy, both among economists and among the public at large.

I don’t think the Efficient Markets Hypothesis is why index funds are becoming more popular. Instead, I think there are three things at play here (and I write this as someone who has money in index funds):

1) User fees. Even if a particular broker manages to beat the market (and it happens), much of the profits will be eaten up by broker’s fees. You’re better off, over the long haul, putting your money in a low-fee index fund.

2) Bet-hedging against financial parasitism. More and more people are realizing that, even though they have to put their money somewhere (or multiple somewheres), when it comes to the stock market, the house always wins, and they’re not the house (e.g., the rise of highfrequency trading). Putting your money in an index fund is safe–you won’t do better than the market, but you won’t get fleeced either. Mind you, this has nothing to do with efficient markets: in fact, it’s predicated on the idea that most people will be intentionally deceived by a few. In essence, this is legalized fraud.

Admittedly, these two reasons reflect my neuroses: whenever someone says, “My broker recommends..”, I think, “So his broker is trying to dump shares of shit he got stuck with.” Just my thoughts.

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3 Responses to Index Funds Are Not Evidence of Efficient Markets: Why Investor Psychology Matters

  1. Noah Smith says:

    Hey!

    Yeah, I’m sure fees and agency problems are a big part of it.

    But if you look at what people say when they sell index funds, the (weak-version) EMH figures prominently. Every intro financial textbook trots out the performance of index funds as the big piece of evidence that the Weak EMH is true.

  2. EpiGrad says:

    Fees are a huge part of it. My broker’s index funds are free. The commission for stock trades is a non-trivial drain on returns until you get up to fairly large transactions.

  3. Kaleberg says:

    If you quit your job, took some training courses, subscribed to every information service out there, you might think you could beat the market, but there are hundreds of mutual funds out there run by people who have no other job, lots of training and access to every bit of information, and they cannot outperform index funds for any length of time. Sure, if you are an insider or lucky, you can win big in a crapshoot. Hell, my lawyer payed for law school by winning small pots in the state lottery, but that can’t be the plan. Otherwise, you have to go with the evidence, and the best evidence suggests index funds, though I imagine that someone, even now is working on a mechanism to manipulate the indices to their advantage.

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