Indexing

Believers of the random walk theory and efficient market hypothesis believe that it stockpicking is a myth and that while an individual may achieve a certain amount of success, it is unsustainable and will lead to a reversion of mean in the long run. Therefore they suggest investing in a certain stock index like the S&P 500 index, which will lead to optimal returns in the long run. Their belief is furthered by the fact that most mutual funds do not beat the market.

Since WWII, the S&P 500 has returned about 9-10% compounded annually. However, this may be misleading, and Buffett said, “Equity returns cannot surpass business returns indefinitely.” Since 1896, the Dow Jones Industrial Average has only returned about 5.3% compounded annually.

A paradox of indexing is that if everyone indexes, then the index becomes extremely overvalued, and the benefits from indexing are diminished. The rest of the stock universe, which would be orphaned, may actually present better opportunites, as they are shunned by the investors who worship indexing. According to some people interviewed in “Stock Market Wizards”, large cap stocks gained in value in the 1990s while many other stocks(excluding the dotcoms) lagged, due to the fact that more investors were piling money into index funds that were heavily weighted in the giant companies.