"in the study of such complex phenomena as the market, which depend on the actions of many individuals, all the circumstances which will determine the outcome of a process… will hardly ever be fully known or measurable."
The above quote is from the 1972 Nobel prize lecture of Austrian economist Friedrich Hayek who wrote brilliant works that explained the errors of fascism and socialism. He taught that the modern economy has too many variables for one person, or organization, to efficiently allocate its resources. Hayek argued that the price system does a better job of allocating resources than a government controlled system. Hayek's observations are part of his reflections on spontaneous order - which is the idea that order comes out of chaos when many self interested individuals are involved. This idea is played out in many areas. A recent example of spontaneous order is the open architecture software - Linux, which is written by programmers from all over the world who, in their spare time, add to the code. Linux now operates some of the fastest computers in the world and is the operating systems that runs many devices that we use in our daily life.
So how does this apply to investing?
The investing world is divided by those that believe they can predict economic and investment trends - the active managers, they believe they can predict which stocks to pick for your portfolio or mutual fund. Then there are those that believe that the stock market is too complex to make those decisions accurately on a consistent basis (the indexers). The indexers argue that the collective wisdom of all the investors in the world will average out to the best answer. The indexers, one could say, are Hayekian in their thinking. They would argue that if Wal Mart makes up 2% of the stock market, then an individual investor should own 2% of Wal Mart.
What is the collective wisdom of all investors in the investing world? Answer: index funds.
What is the record of index funds? Answer: Over time, they outperform active managers. Yes, year to year some active managers outperform the average. But it is not the same ones on a regular basis.
Spontaneous order seems to play out in stock funds. It explains why index funds outperform active managers. The collective wisdom of the many results in better investment performance than that of one or a few.
What does this mean for the average investor. It means that the best course of action has been to hold a well diversified, risk appropriate portfolio of the global stock and bond market, fund it with index funds, and rebalance annually.
For an analogous column, see Russ Roberts's 2004 Business Week column : "The Bagel and the Index Fund,"
I recommend Russ Roberts's podcast: Econtalk, his blog: Cafe Hayek, and his books: "The Choice", "The invisible Heart", and "The Price of Everything."
Roberts is a professor of Economics at George Mason University
In another related article, see Jason Zweig's January 8, 2011 Wall Street Journal Column, in which he also cites Hayek in his explanation on why forecasters rarely get forecasts correct:
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