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The Indexing Paradox -- Be Thankful for Irrational Investors

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  • David Eagle

    (Eastern Washington University)

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.

Suggested Citation

  • David Eagle, 2005. "The Indexing Paradox -- Be Thankful for Irrational Investors," Finance 0512034, University Library of Munich, Germany.
  • Handle: RePEc:wpa:wuwpfi:0512034
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    File URL: https://econwpa.ub.uni-muenchen.de/econ-wp/fin/papers/0512/0512034.pdf
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    References listed on IDEAS

    as
    1. Grossman, Sanford J & Stiglitz, Joseph E, 1980. "On the Impossibility of Informationally Efficient Markets," American Economic Review, American Economic Association, vol. 70(3), pages 393-408, June.
    2. Ross M. Miller, 2005. "Measuring the True Cost of Active Management by Mutual Funds," Finance 0506010, University Library of Munich, Germany, revised 02 Aug 2005.
    3. Carhart, Mark M, 1997. " On Persistence in Mutual Fund Performance," Journal of Finance, American Finance Association, vol. 52(1), pages 57-82, March.
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    Blog mentions

    As found by EconAcademics.org, the blog aggregator for Economics research:
    1. Wisdom of crowds - a puzzle
      by chris dillow in Stumbling and Mumbling on 2008-01-22 20:31:11

    More about this item

    Keywords

    index funds; indexing paradox;

    JEL classification:

    • G - Financial Economics

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