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January 06, 2005

Index Funds and Volatility

Is all this investing in index funds bad for the market? To restate it, at what point does all this investing in index funds become bad for the market?

Index fund investing is based on the idea that since it's incredibly hard to beat the market, it's a better use of your time not to try. Market returns average 8% a year after inflation, which is pretty good, and good enough for most people.

That it's incredibly hard to beat the market is based on two piece of theory. One is the Efficient Market Theory, that information is so quickly absorbed into a stock's price that you can't get ahead of it. The other is the Capital Asset Pricing Model, which argues that there's exactly one mix of assets that optimizes return for a given amount of risk. Put these two together, and you decide very quickly that you should just find that optimum portfolio and let your money sit there, rebalancing every once in a while to account for some companies doing better than others.

Of course, nobody really believes these things.

At least securities analysts and portfolio managers don't, which is why they do what they do for a living. But for most people, told that they can eliminate risk over the long term and make great returns, without having to wire money to Nigeria, will try to do just that.

Over history, most investing has been done on a security-by-security basis, building portfolios that satisfy certain criteria, but nonetheless are composed on individually-evaluated stocks. Index funds are just a way of capturing market efficiency without having to do all the work.

So here are the problems: First, excessive investing in index funds will increase market volatility. Therefore, second, it will decrease market efficiency in allocating capital. Third, it can become an excuse for analysts and investors to become lazy.

It will increase market volatility by reducing the ability of the market to act as a balanced portfolio. Instead of moving independently of each other (in terms of investing, not in terms of economic factors), index issues will be traded in tandem. Instead of balancing out each other's volatilities, index issues will instead tend to reinforce those movements.

To the second point, this means that good companies will be rewarded less than they would have been, and poorly-managed companies will be punished less. If you're trading AT&T and IBM together, simply because they're part of an index, you're not taking into account anything specific about AT&T's and IBM's management or prospects. Instead, you're treating them as a single security, even though they are completely difference entities.

The last point. In theory, the market is only efficient because people seek out information and try to apply it to stocks. That's the only way information makes it into the market. Index trading takes advantage of that efficiency without contributing to it.

This model certainly does have some assumptions built into it. For instance, we have no idea at all if or when these effects would start to make themselves felt. People are ingenious, and would find ways other ways to invest that took advantage of whatever inefficiencies were introduced. We don't even know if index trading even is introducing increased volatility. I hope to use my last term at DU for an independent study on the matter.

But the logic itself looks pretty good, and it does have one whopping implication for public policy. If and when we do allow private Social Security accounts, we should be very, very careful about what restrictions we place on peoples' investment choices. A massive infusion of cash, in a way that increases market volatility, would only make those who don't trust people not to lose their money into self-fulfilling prophets.

Posted by joshuasharf at January 6, 2005 07:22 PM | TrackBack

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