Why Passive Investing Makes Even More Sense in Inefficient Markets

Passive investing makes a lot of sense in efficient markets. After all, if trying hard isn't going to get you ahead, you might as well diversify as much as possible and keep costs low. But, counterintuitively, passive investing makes even more sense in inefficient markets.

Imagine there are only two kinds of investors: skilled and unskilled. In a perfectly efficient market, this distinction doesn't matter--by definition, everyone has the same expected return, before fees, for any given level of risk assumed. The winners are the ones who give up the least amount of market returns to frictional costs. In a perfectly inefficient market, everyone's expected return is purely a function of their skill. The most extreme version would be a market where one person is so skilled he reaps all the excess returns at the expense of all other players.

Obviously, if you're unskilled, you'd rather play in the efficient market. As long as you don't lose too much money to fees and taxes, your results will likely be similar to a skilled investor's, on average, for any given level of risk assumed. You can't hurt yourself too badly as long as your portfolio is reasonably diversified and cheap.

The situation becomes dangerous if you're unskilled and the market is inefficient. Any deviation from market-cap-weighting is likely to hurt you badly, because someone skilled is going to buy what you're selling and sell what you're buying. In this case, the optimal strategy is to not play the game and passively own the entire market, guaranteeing that you will at least be above-average after fees.

I can think of two reasons why unskilled investors would voluntarily play in an inefficient market: 1) they are delusional, unaware of their own incompetence, or 2) they are willing to lose money for the thrill of playing. Most investors who play do not do so with the expectation of losing, so there must be lots of delusional investors.

A rational, introspective person would realize it's possible he is one of those too unskilled to recognize his own incompetence. Once he takes into account the uncertainty of his own status as skilled or unskilled, he would not play the game or scale down his active bets in order to hedge the possibility that he's unskilled.

In short, efficient markets make it safer to be an active investor, because the most you can lose by in expectation is whatever fees, taxes, and transaction costs you pay. Inefficient markets are dangerous for most investors, because they become fresh meat for the apex predators. Either way, efficient markets or not, low-cost passive investing is the winning strategy for most investors.

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