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The Indexing Paradox -- Be Thankful for Irrational Investors

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Author Info
David Eagle (Eastern Washington University)

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Abstract

This paper introduces the indexing paradox, which states that it if all investors are rational with rational expectations and have a common risk-averse investment performance measure, then no investor can expect to do better than the market. If the cost of indexing is less than the cost of active investing, then all investors would index, which would result with no mechanism to price the possible investments. This paradox relies merely on understanding averages. It does not rely on markets being “informationally efficient,” as demonstrated in a model where different investors have differing degrees of informational advantages and disadvantages.

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Paper provided by EconWPA in its series Finance with number 0512034.

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Date of creation: 30 Dec 2005
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Handle: RePEc:wpa:wuwpfi:0512034

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Related research
Keywords: index funds indexing paradox

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G - Financial Economics

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References listed on IDEAS
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  1. Carhart, Mark M, 1997. " On Persistence in Mutual Fund Performance," Journal of Finance, American Finance Association, vol. 52(1), pages 57-82, March. [Downloadable!] (restricted)
  2. Tower, Edward & Reinker, Kenneth S., 2004. "Index Fundamentalism Revisited," Working Papers 04-07, Duke University, Department of Economics. [Downloadable!]
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  3. Sanford J. Grossman & Joseph E. Stiglitz, 1980. "On the Impossibility of Informationally Efficient Markets," NBER Reprints 0121, National Bureau of Economic Research, Inc.
    Other versions:
  4. Ross M. Miller, 2005. "Measuring the True Cost of Active Management by Mutual Funds," Finance 0506010, EconWPA, revised 08 Jul 2005. [Downloadable!]
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