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Passive investing is a game of chicken

Trading Finance Tue Jan 15 2019 07:00:00 GMT+0000 (Greenwich Mean Time)

Imagine 2 cars rushing head-on on an empty road. Both drivers put each other to the test by playing a game of chicken. The first driver to swerve his car to safety - the 'chicken' - is handing bragging rights to the other. If both drivers keep their trajectory however, a potentially fatal collision could ensue. This game creates an interesting situation where each player, in attempting to secure his best outcome, risks his worst. This characteristic defines a game of chicken with any number of players.

Now, what does this have to do with stock market investing? Well, investing consists in buying stocks before others get involved, so that when they do, you can sell back your stock at higher prices on the growing demand. It is clearly impossible to systematically pick individual stocks that will become investor favourites, but it is observed and documented that stock indices tend to trend upwards over time, while being sporadically prone to violent downward corrections. After all, Warren Buffett's typical investment recommendation is 'a low-cost S&P 500 index fund', basically a passive buy-and-hold strategy on diversified portfolio of stocks. But, why is there such a strong belief in the investing community that long term, stock price inflation always prevails? Well there are 4 reasons for it.

1. Technological advances

Research and Development activities constantly discover more effective ways to create and capture economic value. Over time, these advances improve productivity and operational margins for companies, which in turn, rises their intrinsic values.

2. Central banks are considered as safety nets

Recent history has shown that in western economies, central banks indirectly act as lender of last resort for large institutions facing economic difficulties. Quantitative easing and negative rate policies have been aggressively used to prop up capital markets when the real economy was hit by crises.

3. Corporate conflict of interests

There is an unhealthy dynamic between executive directors and shareholders whereby, in exchange for bonus promises, CEOs could prop up share prices through organising buy-back schemes. In a setting with cheap access to external funding, this dramatically increases the probability of upside surprises on stocks as this scheme is used all too often.

4. Controlling inflation is a central bank mandate

Central banks use monetary policies to ensure a stable level of inflation. This means that positive asset inflation is often caused by those adjustement in monetary policy to stimulate the economy.

Since it is also very difficult to predict when those sporadic price corrections will occur, passive investors just continually buy, pushing their investment yield down while raising the risks for a big loss. They basically hope for a best outcome while risking their worst one. They basically play a game of chicken."

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