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A Fulfiled Prophecy

04/17/2017

In 1949, Robert Merton wrote a book entitled Social Theory and Social Structure.  In it, he coined the expression of “self-fulling prophecy”, which is a prophecy, even a false one, that is made true by the actions of people.

For example, the value of a stock reflects supply and demand for that stock.  If Warren Buffett predicted that a certain stock was going up, other people would increase their demand and hurriedly buy that stock, which would drive up the price of that stock.  His prophecy would come true because of what people did.

A friend and client owns stock in a small public company and was wondering what impact it would have on the stock price if they became part of the Russell 2000 index.  I assured him that it would only help his  stock and not hurt it.  The reason is that all indexers or ETF managers or passive investors would be required to own his stock.  Right now, nobody is required to own that stock.  Thus, being included in the index increases the demand for that stock, which increases the price of that stock.

There have always been good investment managers, bad investment managers, and some really bad ones.  Indeed, there have always been times when an investor was better off just throwing a dart on the stock page (called the Random Walk theory) than paying an investment manager to pick stocks.  Eventually, some investment managers realized it would be a great marketing theory to argue that passive ownership of stocks arbitrarily listed in an index was superior to the active management of a portfolio.  The fear of picking a bad investment manager was therefore eliminated.  It was a great marketing scheme, and the argument has been raging for decades since then.  But, no more?

Recently, Standard & Poor’s published their analysis of the last fifteen years, which demonstrated the superiority of not picking stocks over actually picking stocks.  The conclusion is pretty obvious, but I wonder if it was always that way, or it has become that way, due to the marketing success of such giants as Vanguard.  Think about it — as more people were buying index products like SPY, which owns only the 500 stocks listed in the S&P 500, there were relatively fewer people to buy the thousands of other stocks that were NOT listed in the S&P.  (Some smart lawyer could argue that was discrimination against stocks outside the blessed 500.)

Much has been written in the academic literature recently about “over-fitting” or “p-hacking” which are statistical techniques used to bend data to support a predetermined conclusion.  While it does have some statistical rigor, it is intellectually ambiguous, to be kind.  Mark Twain was ahead of his times when he complained about “lies, damn lies, and statistics.”

My disappointment with the latest analysis is that it is all statistics and doesn’t explain why logic has no place in the discussion.  For example, since passive investors (index investors) have to remain fully-invested and cannot increase their cash level, how can passive investing possibly out-perform active investing during a bear market?  Yet another question is that, while investment data for the largest companies is widely known and offers no information advantage to investors, that is certainly not true for small companies, where information is very unevenly distributed.  Passive investing should not work nearly as well for small companies as large companies.  Is there no room for logic in statistics?

Although the Tipping Point is apparently behind us, where the notion that passive investing is better than active investing is made true by the actions of people, important questions remain.  One is whether investors are better off if they own indexes and don’t know the companies they own . . . and don’t own?  Is American business better off when there is a semi-permanent class of stocks that get an unfair advantage, just by being in the index?

Of course, the Standard & Poor’s published analysis must be correct.  After all, I did read it on the internet.

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