If someone came to you today and asked, “What’s the case for index investing?” what would you say to that person?
In light of Warren Buffett’s recent sale of his Vanguard Index Fund position, advisors and clients may be more interested than usual in the case for index investing.
There’s a good case for index investing, but before we discuss it, let’s briefly review the idea of investment indexing. We’ll then discuss the theoretical case for market efficiency.
Perhaps the person with the best claim to inventing the idea of index investing is Alfred Cowles. In 1932, near the bottom of the stock market after the great crash, Cowles established the Cowles Commission for Economic Research.
The commission’s motto was “Science is Measurement.” I mention that because it reflects a certain narrowness of thinking that still afflicts some people in the index investing world. Science is of course much more than measurement, otherwise tailors and carpenters would be among the world’s leading scientists.
The year after establishing the Cowles Commission, Cowles published what may be one of the most consequential papers in the history of economics. That paper, Can Stock Market Forecasters Forecast?[1] was published in 1933 in the journal that he founded, Econometrica.
Cowles’ answer to his titular question was “no.” Here’s part of his summary. Remember, this is from 1933, nearly 100 years ago.
“Sixteen financial services, in making some 7500 recommendations of individual common stocks for investment during the period from January 1, 1928, to July 1, 1932, compiled an average record that was worse than that of the average common stock by 1.43 per cent annually. Statistical tests of the best individual records failed to demonstrate that they exhibited skill, and indicated that they more probably were results of chance.”
The Cowles Commission reported in 1944 that Cowles had updated his 1933 study, and still found no ability of experts to successfully predict stock returns. The 1944 report states:
“The records of 11 leading financial periodicals and services, over periods varying from 10 to 151/2 years since January, 1928, failed to disclose evidence of ability to predict successfully the future course of the stock market.[2]”
It is probably no coincidence that Cowles was associated with the University of Chicago, as were many of the influential economists who developed the theoretical basis for index investing.
In 1952, Harry Markowitz was a research fellow at the Cowles Foundation when he published a paper titled Portfolio Selection in the Journal of Finance.[3] This paper began what is now generally called Modern Portfolio Theory, and the paper continues to be influential. Markowitz was awarded the 1990 Nobel Prize in economics for this work.
The next big development was probably Paul Samuelson’s Proof That Properly Anticipated Prices Fluctuate Randomly,[4] which he developed alongside his MIT colleague Paul Cootner’s The Random Character of Stock Market Prices.
The idea of random fluctuation in stock prices was a central idea in Eugene Fama’s 1965 paper Random Walks in Stock Market Prices.[5] For the non-academic reader, Princeton’s Burton Malkiel published A Random Walk Down Wall Street in 1973. Malkiel’s book has sold over 1.5 million copies, and is now in its 12th edition.
Theory: Efficient Market Hypothesis
Eugene Fama, at University of Chicago, is generally credited with putting these ideas together into the Efficient Market Hypothesis.
That hypothesis is based both on the empirical observations that it is very hard to predict stock prices, and the theoretical insight that in a competitive market, the profit motive should make easy to exploit trading opportunities hard to find, and of limited profitability.
The Efficient Market Hypothesis rests on empirical observation, and theoretical reasoning.
The main empirical observation, the formalization of which owes much to Cowles, it that it is very hard to predict stock prices successfully and consistently.
The theoretical reasoning is that in a competitive market, actors who want to make a profit will work hard to make those profits. So, there will be very few easy-to-exploit trading opportunities – because people will discover and exploit them up quickly.
The theoretical argument for efficient markets is reflected in a joke that was probably already old when I heard it decades ago. The joke goes something like this:
Two economists are walking down the street. One of them sees a $20 bill lying on the ground and exclaims, ‘Look, there’s twenty bucks!’ The other economist, who doesn’t see it, says, ‘There can’t be. Someone would have already picked it up.’
Efficiency
By “efficient” Fama and others mean that it is difficult (or impossible) to consistently earn profits by forecasting the future returns from stocks (or other investments).
Competition and Efficiency
The existence of competition explains why it is difficult to consistently outperform “the market”. The market for stocks is different from most other markets for three reasons. First, stock prices are extremely visible compared to prices of most other goods. Second, important information is publicly disclosed on a quarterly basis, and third the prices themselves are almost constantly changing.
Because anyone who wants to see the price of a stock can see it, and can trade it, there is a great deal of competition. If a stock is “too cheap,” anyone who sees it trading cheaply, and has some capital, can buy that stock. Hence, there is almost always a large pool of capital ready and able to buy a stock if it gets “too cheap.”
Similarly, there are always owners of stock ready and able to sell that stock if it gets “too expensive.”
This is the simple profit-seeking dynamic that, in theory, should make certain that stock prices always reflect the consensus of the (capital weighted) market opinion about the value of the stock.
Theoretical Case for Efficiency
Competition is main conceptual argument for why it should be very difficult to “beat the markets.”
The effect of competition is most easily demonstrated in the case of arbitrage. Classical arbitrage is the sale of one asset to one buyer and the simultaneous purchase of the exact same asset from a seller. For example, if shares of Apple are trading in New York at $250, and at the same time are trading in London at the currency-adjusted equivalent of $249, arbitrageurs will buy Apple in London and simultaneously sell it in New York until the prices are sufficiently close that there is no further profit.
The case of classical arbitrage is particularly clear because essentially all the necessary information – the prices in each market, the exchange rate, and the costs of making the transactions – are easily known with certainty.
The same idea applies to the markets for all publicly traded assets. The difference is that it is harder to know the “absolute” value of an investment than the relative value.
Here’s what I mean by that. If Apple is trading at $250 in New York, and $249 in London, an arbitrageur doesn’t require any knowledge or opinion about what Apple will be worth tomorrow. Similarly, the arbitrageur doesn’t need any knowledge or opinion about Apple’s “intrinsic” value, nor the relative value of Apple compared to any other investment. The only two values that matter are the prices at that moment in New York and London.
In contrast, if an investor is deciding between owning, say, Apple and Microsoft, that investor will require some knowledge or opinions about the relative values of the two companies. The information required to reach a conclusion about those relative values is harder to define and agree upon than the information required to know if an arbitrage opportunity exists.
Fama and others reasoned that with thousands of smart, well capitalized people attempting to earn above-market returns in the stock market, earning such above-market returns should be difficult, at best.
Is it?
History: Empirical Evidence
Fortunately for our examination of the evidence, the historical returns on US stocks are well documented. The University of Chicago’s Booth Business School hosts an entire research center, the Center for Research in Securities Prices, or CRSP, dedicated to looking at the history of stock performance.
It is probably not an exaggeration to say that the study of the efficient market hypothesis has become a mini-industry within academia. Since Eugene Fama’s 1970 paper[6] was published, that paper has been cited an estimated 45,000 times by other papers, and there are probably many more studies that don’t cite it.
Are the Markets Efficient?
The $64,000 question, or more accurately the multi-trillion-dollar question, is whether and to what extent the markets are efficient.
Fama and most of the academic community believes that markets are on the whole extremely efficient.
While the evidence is not conclusive, most people agree that, at best, it is very difficult to consistently earn returns in excess of the “market” returns.
And that brings us back to the question of what is “the market.”
Which is the subject of our next post.
Next steps
This post discussed the theoretical case for market efficiency. Next week, we’ll talk about what “the market” is.
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[1] Econometrica, Volume 1,Issue 3 (Jul.,1933), 309-324.
[2] Cowles Commission for Research in Economics, Report for 1944, University of Chicago, p. 7.
[3] “Portfolio Selection”, Journal of Finance 7 (1952), pp. 77–91.
[4] Industrial Management Review, 6:2 (1965: Spring) p.41
[5] Financial Analysts Journal, Volume 81, Issue 1 (2025)
[6] Efficient Capital Markets: A Review of Theory and Empirical Work, Journal of Finance, Vol. 25, No. 2, May, 1970
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