Ever play the telephone game as a kid? You know the one: Everyone sits in a circle and the first person whispers a common phrase into the ear of the next, then the next, and the next.
The last person blurts out the now impossibly mangled message. “Loose lips sink ships” turns into “Goose hips link sips” and everyone laughs.
That’s a good illustration of the power of index fund investing.
The bottom line is, information is power. We’ve come a huge distance in terms of information sharing. Just 20 or so years ago the Internet was still new and global phone calls a luxury.
Now you can ring a phone in the hip pocket of a Tokyo tourist from anywhere in the world. Reams of data are added to the web every waking second.
We know everything. So why don’t we know the price of, say, IBM?
Because of the telephone game. Companies are opaque, but a lot of what they do and how they perform is readily available knowledge to stock investors. We know how many people own a given stock, how many want to own it and how many are selling. We know earnings, overhead, supply chain data.
Yet there is distortion in the air. Like in the telephone game, everyone gets a slightly different version of the “truth.” We know something but not everything. Our information is subject to change. Things happen, often without warning.
But the game keeps on going, and we adjust our expectations in real time to compensate. That’s why markets are called “efficient” by academics. They are not perfect, but they certainly know all there is to know — now more than ever.
So how does an index fund clear up the distortion problem? Simply enough, the index fund investor hear all of the voices, all the time. Prices for index funds reflect that ongoing conversation about prices in the markets. It is neither too high nor too low. It is correct. It is efficient.
People hate this idea, naturally. They like to believe that their information is superior. However, even the tip-top managers of major companies know better than to try to outguess the market on their own firm’s value.
Whatever data they are privy to is very quickly assimilated by the market, and that shows up in index fund prices nearly instantly.
Insider trading is possible, of course, but increasingly hard to pull off in our interconnected age. Meanwhile, investors who try to outrun or outguess the market are too often roadkill along the way.