Many people have been won over to index funds and passive investing [1] because index trackers are cheap, and it’s not worth paying more for active managers who overwhelmingly fail to beat [2] the market.
But have you ever wondered why index trackers are able to do just as well as tens of thousands of the world’s best paid [3] professionals?
After all, you would be unwise to trust your brain surgery to whoever offers to chop your skull up most cheaply.
And while the relationship is far from perfect (Beats headphones [4]
No surprise then that passive investing still feels wrong [5] to so many people.
But as the following video from Sensible Investing [6] explains, when it comes to investing it’s really quite simple.
Share prices at any time reflect the best guess of all those thousands of highly-informed market participants. In theory, the market is literally the most educated estimate of a company’s valuation that humanity can come up with.
Any new information is quickly reflected in the price, too.
Therefore only those with inside (that is, non-public) information will theoretically be able to beat the market, except through luck.
And there’s more.
Even if somebody has some exceedingly rare ability to better predict what all that available information means for the future of share prices – and so outperform – they can only gain at the expense of somebody else.
Any winner must be matched by a loser, and so the overall expectation [7]of active stock pickers must be zero.
The French connection
Something else that’s highlighted in the video is the role of 19th Century French PhD student Louis Bachelier [8]
At age of 22 Bachelier came here to Paris to study at the Sorbonne. Among the eminent mathematicians whose lectures he attended was the world-renowned Henri Poincaré. It was also in Paris that Bachelier developed an interest in the workings of the financial markets.
After graduating, Bachelier stayed at the Sorbonne to study for a PhD. His specific focus was how stock prices moved. Detailed study of the data led him to conclude that:
- all the available information is already included in the price of a stock
- prices react to new information which is, by nature, random
- therefore, price movements are also random (or, as he rather colourfully put it, no more predictable than the steps of a drunkard).
In conclusion, Bachelier said, “the expectation of the speculator is zero”.
We tend to hear a lot more about the US academics like Eugene Fama and Paul Samuelson who brought Bachelier’s theories to wider acceptance, as well as Jack Bogle who put theory into practice by devising index funds [10].
Trust a French intellectual to think the unthinkable first!
Check out the rest of the videos in this series [11]so far.