Even if the Market is Inefficient Index Funds are Best

By on January 11, 2010

Jason Zweig makes the case for index funds even in an inefficient market for most investors:

Thus, it’s important not to draw the wrong conclusions from the market’s inefficiency. “The evidence does suggest that the market is not rational,” says Meir Statman, a finance professor at Santa Clara University in California. “But watch out for the voice of the devil inside of you saying that therefore it must be easy to beat the market.”

For one thing, hindsight blinds you to the truth. Last March, in the bowels of global financial panic, it was far from clear that Bank of America would survive and that the stock was dirt cheap.

The market had priced such companies as if they might go out of business because plenty of information suggested that was a possibility, and because fear was then so pervasive that optimism felt almost like a form of irrationality.

So, while it may seem obvious today that Bank of America is a survivor, most investors didn’t think the market price for the stock was too cheap last March. As Prof. Statman puts it: “The market may be crazy, but that doesn’t make you a psychiatrist.”

Looking back at how cheap stocks got last spring, you may conclude that any idiot should have known to be buying them hand over fist. But mutual-fund investors sold out of stocks all year long; in March alone, at the very moment when stocks were cheapest, fund investors dumped $25 billion worth.

SMA Comment: The bottom line is that the general public should stick to index funds, or buy a sufficiently diversified basket of stocks and just leave it alone.

Source: The Wall Street Journal

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