This book is, in my opinion, a great introductory book for beginner investors. At the end of the book, the author includes an interesting essay where he refutes a lengthy paper published by a well-known Wall Street investment research institution. This paper argues that “index fund investing does more harm than good to the investment market.”
The issues raised in the paper criticizing index investing can be simplified into what I call the “Index Investing Paradox.” Why is it a paradox? Because passive investing relies on the market’s efficiency — meaning that information flows freely and prices always reflect true value. The logic of passive investing is to avoid frequent trading based on market information. However if the vast majority of people passively invest in indices, how can capital circulate quickly to ensure market efficiency?
The more fundamental criticism is that index funds might grow to such a size that stocks could become massively mispriced. If everybody indexed, who would ensure that stock prices reflect all the information available about the prospects for different companies? In a world with 100% indexing, who would trade from stock to stock to ensure that the market was efficient?
The author of “A Random Walk Down Wall Street” offers this answer: professional traders and hedge funds. They use more specialized skills and tools to seek arbitrage opportunities in the market. Their incentive mechanism is not the “management fee,” but rather profiting from arbitraging mispriced assets.
The stock market does need some active traders who analyze and act on new information so that stocks are efficiently priced and sufficiently liquid for investors to be able to buy and sell. Active traders play a positive role in determining security prices and in turn how capital is allocated.
In our capitalist system it is inconceivable that some trader or hedge fund would not emerge to bid up the price of the stock and profit from the mispricing. In a free-market system we can expect that advantageous arbitrage opportunities are exploited by profit-seeking market participants no matter how many investor index.
It still boils down to the fundamental topic of “incentive” which is a reflection of human nature: Who is more motivated to promote market efficiency — fund managers who are only incentivized by collecting “management fees” or traders whose incentive is to arbitrage mispriced assets?
Of course, this is an extremely simplified assumption about incentive mechanisms. The actual financial market is much more complex. And the charm of finance lies in the fact that this complex system makes rational use of human nature, including people’s greed and fear, to help with risk transfer, resource circulation, and ultimately accelerating human development.
One of my own immature views:
In the current market, some actively managed funds and amateur day traders are essentially paying to contribute liquidity to the market. Only a small portion of fund managers and some professional traders seize arbitrage opportunities and profit from mispriced assets, thus promoting market efficiency. Beginner investors who have overcome greed, by passively investing in this relatively efficient market, can ride the tide and win effortlessly.
To be sure, index investors are free riders. They do receive the benefits that result from active trading without bearing the costs. But free riding on price signals provided by others is hardly a flaw of the capitalist system, it is an essential feature of that system. In a free-market economy we all benefit from relying on a set of market prices that are determined by others.
Reference：
