What is the aggregate cost of trying to beat the stock market?

by on March 10, 2008 at 1:10 pm in Economics | Permalink

Investors collectively spend around $100 billion a year trying to beat the stock market. That’s the finding of a rigorous effort to measure the total costs of Americans’ efforts to surpass the returns they would have received by simply holding a stock index fund. The huge price tag helps explain why beating a buy-and-hold strategy is so difficult.

Here is much more, and from Felix Salmon.  You can think of this sum as the amount it costs to keep markets relatively efficient, a source of societal fraud and rent-seeking, a Nash equilibrium mixed strategy (no one tries to beat the market on every margin), a donation to the broader social good, or most properly all of the above.  Interfluidity adds comment.

happyjuggler0 March 10, 2008 at 1:52 pm

My biggest problem with those who claim buy and hold as a default option is that such a policy is awfully hard to maintain in practice, noting that people are emotional humans, not machines willing to follow the advice of obscure professors.

How many people bought into the notion of buy and hold, and following that advice they held the Nasdaq index as part of their portfolio, right up until late 2002 or early 2003, when they instead cried uncle and dumped their entire position and then bought houses as an investment instead? Care to guess when they capitulate with their housing investments?

ZF March 10, 2008 at 2:16 pm

“You can think of this sum as the amount it costs to keep markets relatively efficient, a source of societal fraud and rent-seeking, a Nash equilibrium mixed strategy (no one tries to beat the market on every margin), a donation to the broader social good, or most properly all of the above.”

Actually I think it’s more properly thought of as part of the entertainment industry. This is not a frivolous point. The more closely you look at how most investment advisors behave, the more economically accurate this classification seems.

Andrew March 10, 2008 at 2:40 pm

You can get Buffett’s letters for free, and if they don’t make sense to you, stop trying to beat the market.

Andrew March 10, 2008 at 2:43 pm

Patrick,

That’s a good question, one these efficient market folks never seem to address. But it’s also not that important. The only stock pickers that matter are the ones who are right. We’d be better off if all the other noisemakers in the market quit trying and tried to do better at their day jobs. If the marginal imbecile quit trying to beat the market, the people who know they are good wouldn’t stop.

Rich B. March 10, 2008 at 2:59 pm

If no one, anywhere, ever tried to beat the market, who would buy (or sell) the stocks that index funds are tied to? And if there were no buyers/sellers, how would their stock prices rise?

Assumedly, retirees and pensioners would sell their index funds (and the underlying stocks) to current investors who are dollar cost averaging every month. Stock prices would be determined by the underlying values of the assets during these regular transactions.

Shiran Pasternak March 10, 2008 at 4:01 pm

While I personally agree with the sentiment, throwing up absolute numbers about how much investors collectively spend per year isn’t effective. Why stop at annual waste? For dramatic effect, why not list the global costs in the entire history of the market?

Would it not make more sense to provide relative measures? Why not compare these numbers to the total money spent on investing, or the money spent to research and invest in index funds? Maybe even divide this number by the number of investors so that we can have a per capita number that we can benchmark against, say, annual income?

Shiran

Alan Gunn March 10, 2008 at 6:27 pm

“You can think of this sum as the amount it costs to keep markets relatively efficient, a source of societal fraud and rent-seeking, a Nash equilibrium mixed strategy (no one tries to beat the market on every margin), a donation to the broader social good, or most properly all of the above.”

Yeah–thank you, stock pickers. I’ve been free-riding on you ever since Vanguard started selling index funds to small investors, and I’m grateful. One additional benefit: you can listen to news people explaining that the cause of any downturn after a good day is “profit taking.” So all this activity has bought us a moron detector, too.

Scott F. March 10, 2008 at 7:53 pm

Patrick, those who believe in an efficient stock market and indexing do acknowledge that active traders
are necessary to maintain the market’s efficiency. Currently a small percentage of shares are held by index funds, so this is not a problem. Nor probably will it ever be, given human nature.

jonm March 10, 2008 at 10:17 pm

I think ZF’s argument this be seen as part of the entertainment industry is a good one, at least for retail investors. It should be clear that they are utterly outclassed in terms of transaction costs and information by institutional players, making high frequency trading of stocks (and even worse, trading options), a wealthy person’s lottery. The only way I can see these people adding information and overall market value is by having genuine inside information like news of an impending drug trial failure.

sean March 11, 2008 at 5:31 am

Evidently we are choosing to right off any value to the economy based on stock picking; when in fact the nature of the profession is to choose which companies to allocate capital to. Who can we lend to and what rate to make it worthwhile. As markets are to an extent now breaking down their is real value to this. Without stock pickers making markets efficient than who chooses not to give capital to bad companies. Ideally, this would prevent dot.com bubbles where bad companies get cash.

Anthony March 11, 2008 at 8:28 am

“The efficient market hypothesis presumes that all investors are equally rational and well-informed.”

No it doesn’t. It presumes that *some* people are perfectly rational and well-informed, and that those people are willing to enter into highly leveraged transactions of boundless magnitude until the market price is driven up or down to the fair value.

It’s still a somewhat ridiculous assumption, at least if you take it literally down to the penny, but not *quite* as ridiculous as your assertion.

R. Richard Schweitzer March 11, 2008 at 10:57 am

Someone should write (after discriminating research) a substantial report on the History of Intermediation (in the U.S., with comparisons to other commercial areas).

The “elimination” or displacement of the function of what used to be called “middlemen” is an ongoing process and succeeds to the extent the market places are “open,” and not constrained by external intrusions (culture, tradition, inertia, governments…).

However, that same degree of openess creates opportunities for some to “make them a job,” partially based on specialization of labor, divisions of efforts; as evidenced by the rise of those who devised and marketed various derivative finacial instruments, established mutual funds, REITS, often creating value from efficiencies, which are succeeded by excessive intermediation (beyond viable needs).

Those are honorable callings, but like so many other callings, they are not always answered by persons who can remain honorable.

Andrew March 12, 2008 at 2:34 pm

Another item the EMT folks never bring up is governance. If everyone bought indexes, there would be no shareholders with concentrated interest enough to offset management. We, in fact, don’t have to go to the theoretical extreme because this is already a problem.

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