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January 23, 2005

Do Privatizers Believe in the Stock Market?

By which I mean, do those pushing social security privatization believe the stock market exists as anything but an abstract investment device? Does it do anything useful, such as allocating capital in an intelligent manner between better and worse uses in our economy?

Apparently not, since according to most reports, any investments in private accounts will be restricted to a handful of potential investment funds to reduce administrative costs and prevent individuals from being too risky. And most expect those choices to be index funds-- broad-based investments in large numbers of stocks across the economy. So instead of choosing better and worse investments, the government through these individual accounts will just be handing out potentially trillions of social security dollars on autopilot.

In responding to my post (and followup) on government investing directly in the stock market, Steve Verdon sees such index funds as avoiding having politics involved in what people invest in:

Another idea would be to use a fund that mimics the S&P 500 index. In other words, remove the discretion from the governments hand.
I'll get back to other points Steve raises about government investing in another post, but let's stay with the virtues of index funds for the time being.

The supposed virtues of index funds derive from what's called the Efficient Market Hypothesis -- popularized by Burton Malkiel in his 1973 book A Random Walk Down Wall Street. The basic idea is that the stock market has automatically priced in all the clever strategies of all the Wall Street pros, so it's essentially impossible to find deals with individual stocks. So it's better to buy an index fund of hundreds, even thousands of stocks, get maximum diversification of risk with the minimum of administration costs, and invest on autopilot.

Now, I actually buy the idea that most mutual funds won't beat the overall market, so I'll do better as an individual investor just betting on an index fund.

But if everyone suddenly adopts that strategy, all hell would break out. As this The Street.com article pointed out a couple of years ago:

Imagine a world in which everybody buys into indexing as a concept and all investable assets wind up in index funds. What would stock prices be like in this world? Completely insane, that's what. There would be bankrupt companies with billion-dollar market caps merely because they were in the index and nobody could sell it. If everyone did this, the markets would self-destruct.
Just picking which stocks are in or out of an index (picking the S&P 500, the Wilshire 5000, or any other alternative) would massively distort the whole stock market. And you better believe that money flowing into these government-designated indexes would go far beyond the social security personal accounts, since once the government gives its endorsement to any index as the best and safest stock vehicle, other private savings will no doubt rush there as well.

But the problem goes beyond just this financial distortion. It reflects the reductio ad absurbum of autopilot investing taken to the society-wide endpoint. As another analyst put it in the Wall Street Journal:

More specifically, the Efficient Market Hypothesis is true to the extent that a sufficient number (sometimes relatively small) of investors believe it to be false. Why is this? If investors believe the hypothesis to be false, they will employ all sorts of strategies to take advantage of suspected opportunities. They will sniff out and pounce upon any tidbit of information even remotely relevant to a company's stock price, quickly driving it up or down. The result: By their exertions these investors will ensure that the market rapidly responds to the new information and becomes efficient. On the other hand, if investors believe the market to be efficient, they won't bother. They will leave their assets in the same stocks or funds for long periods of times. The result: By their inaction these investors will help bring about a less responsive, less efficient market.
There's a bit of a Heisenberg Uncertainty principle going on here-- if the government recognizes the usefulness of index funds, they will destroy it and any usefulness of the stock market in allocating investment in our economy.

This is the fatal flaw in any private accounts strategy. If privatizers allow free choice of any investment, the administrative costs and potentially individual risk-taking gets out of control, but if they restrict investments to just a few funds on autopilot, the whole stock market will be distorted and may careen out of control.

The irony here is that the only way privatizers can sell their plan is by pretending that the stock market doesn't do anything useful, since if it did, we really couldn't buy into the idea that random index investing by all investors made sense.

Posted by Nathan at January 23, 2005 11:44 AM