Investing, and Sharpe’s inequality

See the statement from Sharpe himself.

Hat tip to Matt Levine of Bloomberg.

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2 Responses to Investing, and Sharpe’s inequality

  1. The interesting thing is that security prices would be wrong, meaningless, or undefined if everyone were a passive investor.

    That’s clearly true, because the advantage of the passive investor is that they don’t pay for research; if no one paid for research, there would be no connection between a stock’s performance and it’s price.

    So, the conclusion is that active investors perform a critical function, but it doesn’t benefit them, so they need to lie to collect the money that the market needs to conduct research.

    I.e. the stock market wouldn’t function if everyone were a rational, well-informed investor.

  2. The pros and cons of index investing have been chronicled by Matt Levine at Bloomberg. That said, a couple of points:

    • Most investors are not rational, at least they don’t behave as if they are. This is the result of behavioral economics. While efficient market theory is based upon arbitrage to equilibrate prices incorporating all known possible information, in fact, success in the marketplace depends upon understanding the irrationality of investors as well as fundamentals.
    • The argument that research or, by extension, the recommendations of securities analysts are a gateway to successful assessment of a stock suggests the required and typical publications of the company itself convey no useful information. While they may withhold or be biased, they contribute some useful information, and a smart investor with sufficient time and resources could make assessments of the company and its competitors with some fidelity. If that is true, then research is a convenience or an adjunct, but it is not essential.
    • Irrespective of whether or not there are stock indexes or mutual funds, most holdings are by large funds, such as pension funds. Such funds tend to use a sector-weighted approach to investing. There is little difference between investing in sectors with a portfolio of representative stocks and investing in an index for the sector. This is why, for instance, energy stocks tend to move up and down inversely with the price of oil, even if they are zero Carbon energy stocks.
    • As Levine discusses from both sides of the question, the fact of life in the markets is that, increasingly, capital is being provided from private markets, not the publicly traded ones. Indeed, from an empirical perspective, it is difficult to separate out trends which might occur in the public markets solely based upon factors represented in those markets without considering the effects of large private investment. Such investment, almost by definition, is more difficult to characterize.
    • I would add that not only are investors not rational, even if they are they are severely limited in assessing lag structure between economic forcings and their manifestations in markets. That is, even if they are good at (read “have predictive skill in”) determining there are forcings and pricing them, timing lags for manifestation are not well done.
    • Finally, I’d argue that the point that “Indexes are bad because they destroy research, and that this is a unacceptable therefore should not be done” is a fallacious argument, namely, Camel’s Nose.

    Some pertinent Levine articles on the subject:

    Whistleblowers and indexing
    Snapchat, indexes, and free research
    Wall Street analysts give investors what they want
    Market milking and research troubles
    Expensive research and cheap hedge funds

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