Index investing snatches the fruits of other people’s efforts

May 29, 2023
by Noriyuki Morimoto

In the capital markets, the prices of individual stocks cannot stay efficient all the time; they can be undervalued or overvalued. However, when an unspecified number of market participants buy and sell a large number of stocks based on their own independent judgment, the resulting average price of all stocks is considered to be efficient, or appropriate.

While it is ideal to buy undervalued stocks and sell overvalued stocks, it is always rational and reasonable, if not ideal, to buy neither overvalued nor undervalued, reasonably priced stocks. This means it is reasonable to target the average price of the entire market, i.e., to engage in index investing. This is the theoretical background that justifies indexing.

However, we must not forget that in order for indexes, i.e., market price averages, to be efficient, the premise is that an unspecified number of market participants must buy and sell on their own independent judgment. Therefore, in designing the market system, various efforts are made to satisfy this basic requirement, such as ensuring a certain number of unspecified participants and symmetry of information.

However, no matter how well the system is devised, the market cannot be efficient unless market participants seriously engage in the market to buy and sell individual stocks with their own interests at stake, with their own agendas, and on their own responsibility, in other words, unless the spirit that supports capitalism is carried through.

Selling a stock is an expression of negative evaluation of that stock. Buying is a statement of positive evaluation. No value judgment, right or wrong, can be established for the individual evaluations of such individual market participants. That is why the market average, as the aggregate value of many such different valuations, is considered efficient.

Market participants have a social responsibility to the market to put their own valuation on individual stocks. Only when everyone fulfills this responsibility will the market be efficient. The problem of cross-shareholdings in the Japanese stock market has been based on the argument that relational shareholders are not fulfilling their responsibilities to the market.

Herein lies the problematic nature of index investing. This irresponsibility is the fatal flaw of indexing, which is to take only the results of the rest of the market participants’ fulfillment of their responsibilities without fulfilling their own.

 

[Category /Equity Investment]