Why We Think that Index Investing is not the Best Investing Strategy in Indonesia
There seems to be a better alternative
Index investing refers to purchasing an index of all stocks that are available in the market. Proponents of index investing believe that it is the best investment strategy because it is impossible to identify investment alpha consistently. This strategy is mostly underpinned by the Efficient Market Hypothesis (EMH).
Efficient Market Hypothesis (EMH)
According to Investopedia:
Sounds complicated? No worries, here’s what it means:
It is pointless to search for undervalued stocks or to try to predict trends in the market through analysis.
So, people should just buy the stock market index regularly and they will just do fine over the long run.
This theory could not be more disputable, when it comes to the Indonesian stock market (IDX), with its composite index called “IHSG”.
Before we present more empirical facts regarding EMH, let us evaluate the core assumptions behind this theory.
Assumption #1: Information is costless
In our view, this assumption creates top flaw of EMH that renders this theory inapplicable in real market conditions.
At face value, it is true that information about a company is publicly available. You can go to IDX public expose or company website to download the company’s financial statement. You can see their earnings, debt, number of employees, management, products, etc etc. All of the information here is costless which makes this assumption seems reasonable.
However, it is also really easy to see that information about a public company is voluminous. Financial statements released quarterly usually exceed 100+ pages, companies usually have subsidiaries or parent companies that can be public or private, and many more. Therefore, it requires money, time and effort to process and digest the information into an actionable investment activity.
It is rather brainless to say that those with most money, time and effort to digest this information can have a better picture about the investment opportunity of a company. Let us illustrate this statement with an example:
A busy professional looking at his favourite influencer asking him to invest a company that would 2x in price in under a year. Vs
An analyst who spends hours, days and weeks to study the company’s product and prospects inside out.
Both busy professional and analyst have access to the same publicly available information. But the latter have much more time and effort to dig deep and understand the company better.
With this, although this assumption has some truth to it, it is very far from true when applied to the real world. Information asymmetry exists to a large extent. They create irrational or unexpected behaviours amongst huge swathes of group of people that can present itself as an investment opportunity for others.
Assumption #2: Investors have homogeneous expectations
This assumption stipulates that buyers and sellers in the market have same expectations about current future risk and return of a stock.
When we think about the debunked assumption #1 (costless information), it becomes crystal clear that assumption #2 does not hold.
In fact, the expectations are incredibly variable depending on the amount of digested information that an investor has. For example, an investor called Alice might see that there is an upcoming digital bank that is publicly traded in the stock market. She scrolls the social media and has the following conclusion:
Digital bank is the future and technology will replace all brick and mortar banking.
Funds will flow from big old banks into new digital banks.
New digital bank will grow 100x in size so it is reasonable to expect that stock price will at least 10x in price.
The second the stock market is open, Alice rushes to buy a significant amount of that stock without much consideration.
Introducing a new investor called Bob. He looks at the banking scene (incumbents) and the digital banks’ capabilities. He comes up with the following conclusion:
Cost of funds of a digital bank is typically really high (offering rates that go up to 6-7% p.a.).
Technology capability of a digital bank can be replicated easily by bigger banks.
Digital banks as of today are largely unprofitable and therefore do not yield dividends.
The second the stock market is open, Bob looking at the price of a digital bank right now might end up selling all of his positions if he has any.
We hope that from this fictive Alice&Bob illustration, you can see that expectations of investors are heterogenous, even polarising. This largely stems from the fact that information processing requires knowledge, time and effort. Information, the good and processed one, is never free.
Assumption #3: Investors are rational
We think that investors are never fully rational due to two traits that are wired into all of us:
Even the best fund managers out there still have these two traits. They only try to minimise them as much as they can by introducing investment framework, algorithm and systems.
A common behaviour that we see from greed is none other than FOMO. When we see that everyone is championing one stock to go up and everybody is buying. You will see that price goes up too. We then neglect all risk of purchasing the stocks and FOMO into a position. We can FOMO for long because good information is the only expensive antidote to our irrational behavior.
Another common behaviour we see from fear is panic selling. When there is a market crash, all stocks are bad. But are they? Some are and some are probably not. In fact, those who can step back and clearly see which stocks are being sold at ridiculously cheap prices are the ones who can make a handsome returns. This behaviour is really common because we fear losing money. We would think what the price can continue to go down to zero? Although the underlying company is still performing spectacularly well in such circumstances.
How About Indonesia?
Now that we see these core assumptions are neatly debunked, let us see EMH in action in Indonesia. Assume you are a fund manager with all the fancy finance titles working at a decorated asset management company. You believe that EMH is the be all and end all and you decide to launch a fund back in the day with the goal of replicating the performance of the IDX composite.
Then I am a simple peasant who only banks with Bank BCA and I decide to purchase the stock every month with my modest salary. Lets see how we fan out:
As of Aug 2023, I have just performed ~5x better than the index just by buying one stock.
But you are only cherry picking examples to prove your point. How do you know the BCA is the stock to buy?
What we are trying to get here is the fact that it is not impossible to consistently outperform the index because there will always be
Heterogenous investor expectations, and
When you see it in action, it is often hard to take EMH theory seriously. Therefore, we think index investing is inferior to stock picking undervalued companies that have stellar long term prospects.