Investing - Does a Passive Strategy Help Or Hurt?

I must say that I have no problem with folks buying and holding index funds. Many people have made a lot of money doing it. My problem is when investment advisers say that the ONLY way to make money in the stock market is to buy an index fund or invest "passively". That simply isn't true.

The new idea of efficient markets means that no matter what you do, there is no way to beat the stock market...and if you somehow do, it was a matter of chance or luck. It is an idea that is largely harbored in academic circles and it is based on one fundamental idea:

1. Stocks Reflect All Available Information

If stocks reflected all available information, there would be no way to beat the market. Stocks are information sensitive, and so they are priced largely by information. If all information is already available by the time you go to buy a stock, there is no way that you can profit by buying that stock at a specific time (also known as "timing the market") or by buying one stock over another stock because information is what would give you an "edge" in the market. With all information available, there is no edge. Thus, the only "rational" way to invest is simply to invest in index mutual funds or a collection of stocks that will passively mirror the returns of the stock market as a whole.

The idea rests on a theory that stock prices have one "true" value. There is only one "correct" price and that that price is determined instantaneously by the market. If and as new information becomes available, the price of the stock changes instantly and you can never make any money from it. The stock market is always right. That's why you can't beat it (consistently earn higher than average returns or higher than indexed returns).

Debunking The Intrinsic Efficient Market Theory

"Warren Buffet" - that should disprove the "Efficient Market Hypothesis", but if you need a more comprehensive answer, here goes:

Just as with the subjective method, the intrinsic method is also arbitrary in the pricing of stocks. The reason for the automatically correct and instantaneously self-correcting stock market is unknown and unknowable. It apparently "just happens".

The fundamental theory of the efficient market hypothesis crumbles when we realize that stocks do not in fact reflect all available information. Why? This is partially due to the illegality of insider trading, and various Government regulations. For example: Bill Gates cannot trade on his information about Microsoft because he would be considered an "insider", and would be "guilty" of insider trading if he did. This information does not get reflected in the price of a stock immediately.

The stock market does not reflect the most informed traders.

However, even if we were to discount insider trading eliminating information from the market, the efficient market hypothesis ignores the fact that there must be someone there to make the market efficient. Again, there must be a cause and effect relationship. Markets do not exist in a vacuum and are not arbitrary. Prices cannot be "automatically" correct without someone to make them correct. There must be someone buying and someone selling on information somewhere that causes the price to be what it is. Nothing, from the building of a house, to the pricing of stocks, to the building of an investment portfolio, happens instantaneously. There is always some time involved - some delay. The reason for the delay is that productive work is a dynamic process - not an instant event.

That productive work comes from the traders on Wall Street (yes, they do work believe it or not). It is the people exploiting the small developing patterns, the individuals acting on new information as it comes to the market, it is the savvy investors who are willing and able to buy and sell stock based on that information that creates the efficient market. In short, the reason the market is efficient is because there is money to be made. And...it takes effort, skill, and ability to do the necessary research on companies and to make rational observations and valuations about all of the companies that these traders invest in.

If the intrinsic efficient market theory were valid, then there would be no incentive for anyone to buy any stock because there would be no opportunity for profit. Additionally, if there was no profit to be made by selling, there would be no incentive for an individual to sell their stock. There would be no reason to invest in the stock market, and quite possibly no way to do it - not even in an index mutual fund which would be holding stocks in a stock market where no one would be willing to sell because there would be no incentive to do so. There would be no functional stock market.