Indexing in an Irrational Market

People assert that one of the core assumptions behind index/passive investing is that markets are rational and therefore stock prices are always accurate, reflecting all publicly (and sometimes privately) available information about a company’s prospects.  Therefore, attempts to “outsmart” the market will fail.

However, it is clear that markets are not purely rational.  We cannot rationally justify periods of extreme volatility.   We cannot rationally justify absurdly high stock prices in 1999, nor absurdly low prices in March 2009. Market movements of 3% per day are rarely the result of rational investors responding to new information. In the short term, markets are anything but rational.  The short run is dominated by emotional responses, it is controlled solely by fear and greed.

One may understand this and come to the conclusion that this short-term irrational behavior can and should be exploited. If some market participants are behaving poorly and ignoring the data, cooler heads should prevail. Unfortunately for these cooler heads, the data bears out that they have still failed. Quite frankly, it is not their fault.

Active management, whether it is picking individual stocks, timing the market through tactical allocation or trying to pick “hot” sectors fails not because markets are perfectly rational, but because markets are unpredictable.  A rational person may have thought that stocks looked cheap in October 2009, only to see the S& 500 fall another 400+ points (over 35%) by the following March.  A rational person may have thought stocks were expensive in 1997, only to see the S&P 500 gain another 50%+ over the next two years.  Keynes is famously quoted as saying “The market can stay irrational longer than you can stay solvent.” Being right about the market doesn’t count for much unless you can get the timing right as well, which the luckiest among us may experience once in our lives.

An irrational market also doesn’t eliminate the high hurdles of costs and taxes faced by those who attempt to beat the market.  Management fees, trading costs and tax drag all add up to a significant barrier to successfully taking advantage of an irrational market, and these costs come every year, year after year without fail.  Can you be assured to be successful enough every year to overcome these hurdles? The data suggests otherwise.

Buying a broadly diversified, low cost and tax efficient portfolio of index funds may just be the most sane thing in an insane world.

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