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Comment by weber88 | Hacker News Reader

Just a question that popped into my head: what would happen if everyone followed a passive strategy, ie, no one was active? Isn't some sort of active strategy required, somewhere, for funds to be directed at all?

Though, I do think on average fund managers probably don't actually make anything like useful predictions. But perhaps we do need someone, somewhere, looking for good investment.

My guess is that there is a role in society for some conservative, value based investing, but at the moment there are more people trying to do this than is useful, and even more people trying to find good investments by worthless strategies (like trying to predict future movements from past movements).

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The advice against trying to beat the market is based on the fact that there are tens of thousands of highly intelligent people paid to analyze securities, and they're all feeding off each other's behavior. To beat the market, you have to beat a conventional wisdom based on the accumulated expertise of a lot of people. For instance, if you want to buy stock in a Malaysian steel company, you have to decide that you understand the current value of this stock better than a crowd-sourced price generated by the research of a horde of steel industry specialists, people with intimate knowledge of the Malaysian economy, business environment, and political environment, people who can afford to spend all day reading forecasts of economic conditions in the countries where this company's steel is consumed, and people who have a drink with a VP from the company and get gossip about the CEO's health and the competence of his likely successor.

If no one was trying to beat the market, it would be easy to beat the market. But since so many people are busy trying, it's silly to try to compete unless you want to take it as seriously as the professionals do and get plugged in the way they are.

The "random walk" hypothesis says you can beat the professionals. About half the time. By flipping a coin. But the professionals are insiders, and as well-regulated as the stock market is, I would assume that an outsider playing against insiders in a 50/50 game will not quite win his full 50% share.

The hope that a person can price stocks better than the market as a whole rests on a couple of possibilities:

1. Beating full-time professional analysts at analysis in your spare time, because you're just so bad-ass.

2. Identifying a price that is heavily influenced by ignorant people and beating them by just being reasonably well-informed -- but this is not an original idea and hence is a special case of #1.

3. Finding a niche that you know intimately for some reason, and in which you have no professional competition. Oh, wait, this is just #2 again. Or maybe you found a niche small enough that it doesn't get a lot of attention from professional analysts, and you can make a little bit of money at it. That might work!

4. Being the first one to take into account a new idea or source of information. This one will make you wildly rich, and it's fun to dream, but while you're looking for that brilliant idea, there's no reason to risk real money on your ideas-in-progress.

Or maybe the "analysts" are just not any good.

For a specific example, look at how the "hobbyists" are beating the "professional" analysts at predicting Apple's quarterly performance, time and time again.

http://tech.fortune.cnn.com/2010/04/20/apples-blow-out-quart...

If there's one company where hobbyists will beat professionals, it's Apple. Do you have any other examples?

There are many objective studies that show that individuals with their own specific trading/investing strategies can beat the street. But that's not really the point.

The point is that AAPL is now only second to XOM in terms of market cap, and is not exactly a tiny blip on the radar. It is a stock that is being watched by literally millions. If these "professional" analysts have so many resources at their disposal, have the inside track on confidential information and are operating at such an uneven playing field as the parent postulates, then why would they consistently be beaten by the "hobbyists"?

Well, the fact that Apple is so large actually serves my point: there is a lot of information on Apple. The information asymmetry between hobbyists and analysts is nil for Apple.

In fact, I'd argue the information asymmetry tilts in favor of individuals, considering that analysts publish their forecast. I wouldn't be shocked if these guys use "analyst expectations" as an input.

Anyway, this is bad news for the analyst, because the one resource they don't have is time to focus on one company. Hobbyists, however, can focus on Apple all they want. So I'm not surprised that Apple fans nail their earnings forecast.

You forgot #5: plain dumb luck.

I index for a very good reason, some of the smartest people I know chose to work on Wall Street, and they're putting in 60+ hours a week working on this stuff. If you have tens of thousands of people like that, I don't care how smart you are you just aren't going to beat them. Better to insure you are at least average (which net fees probably puts you in the top 30%) than to chase being in the top 5% and failing miserably.

As you suggest, we do need "value traders". In particular we need traders who buy and sell stocks in reaction to news. These traders don't have to be necessarily the active fund managers the article is talking about. They could be prop traders working for their own account or for a bank, broker or hedge fund.

"News" is any new information that affect the expected present value of a company cashflow. It could be a new product, a possible merge or macroeconomic indicator.

If you invest in an index fund, you're basically following the trades of those value traders. You won't make as much money as them, because often you'll be buying "good" stocks after they've already increased in price, i.e., by the time passive fund managers buy the "good" stock, the price will often have already incorporated the value of the good news. The same holds for the "bad" stocks.

The article answers that. Look around "We need active managers".

There will always be market participants with vested interest in specific shares, and by definition they are following an active strategy by associating with that company. It follows that they will have a vested interest in hedging against dangers that might adversely affect that company.

> But perhaps we do need someone, somewhere, looking for good investment.

Do programs on investment-bank servers perform this function?

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