Larry E. Swedroe (The Quest for Alpha, John Wiley, 2011) sounds like a cynic but he does the saving/investing public invaluable service by pointing out how Wall Street works. The bankers and brokers have yachts; their customers lose their shirts. It is a caricature that hurts because there is a tough grain of truth in it.
In effect, the story is that financial markets are “efficient” because many players, big and small, devote enormous resources to gauging the “correct” valuation of various investments (stocks, bonds, commodities, etc.) that their collective wisdom is, for practical purposes, impossible to beat. Even if one were to think that the market has become “irrational,” such a judgment cannot be made ex ante as a means of getting above-par returns.
The book ends with a simple message: If you, the saver/investor, try to beat the market, you will likely lose, either because you will have made a bad decision on insufficient information, or you will give away too much in fees to those who claim to actively manage your money but will not deliver on their promise anyway. The correct strategy is to buy an index fund that reflects your portfolio preference, and that charges the smallest fee (as low as 0.3%).
Theoretically there is a flaw in Swedroe’s argument. If all were to simply buy an index fund or just do a “buy and hold,” there would be no active investors left. How will market prices be determined? It would be an infinite regress of sorts, of the “After you, Alphonse” type.
I suspect the answer is that there will always be enough active investors who will devote the resources needed for price discovery by a market. Swedroe uses William Sharpe’s 1991 point that it is arithmetically true that, abstracting from fees and search costs, active investors as a group will do the same as the passive investors, i.e., on average the two groups will get the market return in any event. But within the active investors, there will be winners, perhaps not persistent ones, who will earn their keep because they were “ahead” of the others (in the paradigm of picking up the $20 bill on the sidewalk). This prospect of being among the winner group will cause enough investors to remain in the active category, and as Swedroe points out, the passive investors can then “free ride” on the outcome of the transactions of the active investors.
So, there you are. The quest for Alpha is futile for the average Joe, but will seem worth it for enough players, thereby bringing about the efficient market result that Swedroe talks about. This is a case where the illusion of the few or many, as the case may be, will be for the benefit of all. Perhaps this should be named the Swedroe Paradox.
But the myth that active investment pays off will persist and perhaps forever. Such persistence would make buying and reading Swedroe’s book a very cheap antidote for the overwhelming majority of investors.