The dictionary defines suspension of disbelief as a willingness to suspend one's critical faculties and believe the unbelievable. Suspension of disbelief is essential for the enjoyment of works of fiction like movies, books, magic shows etc. However, we humans seem to excel in the art of disbelief suspension in many other areas of our lives as well. Investing is at the top of that list.
In the words of Warren Buffett, price is what you pay and value is what you get. But investing based on value is very difficult to practice. Investing based on value requires one to take a position that the market is wrong. Our belief in prices set by the market or to put another way, our willingness to suspend disbelief about the prices set by the market makes it hard for us to disagree with the value ascribed by those prices. Once the link between the price of a security and the value of its underlying asset is broken due to the voluntary suspension of disbelief by market participants, interesting things start to happen.
Benjamin Graham noted that the market then becomes a voting machine instead of a weighing machine and success begets success and failure begets failure. Graham had said that the markets behave like a voting machine in the short term and a weighing machine in the long term. Unfortunately he did not define the duration of the long term. John Maynard Keynes on the hand did articulate it and said that in the long term we are all dead.
Recent experience in the markets would make one believe that the long term in the market is nothing but a series of short terms and since the market behaves like a voting machine in the short term, it should theoretically also behave the same way in the long term. This hypothesis is being proved by the rise and rise of passive index based investing. The most recent semiannual report on fund manager returns produced by S&P Global (SPIVA report) showed that 90% of actively managed US mutual funds underperformed their benchmark indices. As an active money manager and one who makes a living picking stocks, I have managed to find myself in the 10% of managers who do beat their benchmarks. However, I can tell you from experience that it has been incredibly hard to beat the index and it is getting increasingly harder to do so.
As more money goes into passive index based funds, demand for securities that make up the indices increases and their trading volumes and liquidity increases. The increase in demand leads to higher prices for the indices and securities thereby creating more demand of index based funds. As money skews towards indices and their components, it moves away from non index securities thereby depressing their prices, trading volumes and liquidity. This amplifies the perception that securities in the index are safer than those not in the index and that larger companies, which by definition are in the index, are safer investments than smaller companies. This phenomenon is exaggerated in emerging markets which are less liquid to begin with and are dependent on foreign capital flows.
It is important then to step away from this madness and ask whether the value of the underlying matters? Does the market ever behave like a weighing machine? Can the fictional and voluntary suspension of disbelief result in the emergence of an alternate reality? If we truly are in an alternate reality then again in the words of Warren Buffett, I am out of touch with present conditions, and if not then I believe that this has to all end very badly.