Indexing in Investment Strategies and Behavioral Finance

The aim of this report is to evaluate and validate passive investment strategies and advantages of having index funds in the portfolio. The importance of passive investment strategy is initially justified with the help of theory on efficient markets. The report then provides evidence that indexing still is a vital aspect of investment strategy and is not influenced by the efficient market theory. The report also gives a brief overview on how investors utilize indexing to minimize transaction cost by replicating the market index in their portfolio. Further, the success of indexing in US, UK and bond markets is highlighted with the help of evidence from past research on passive investment strategies. The later section of the report provides brief introduction of behavioral finance and how psychological biases affect investor’s behavior and prices. It also provides its contrasting viewpoint with respect to the Efficient Market Hypothesis (EMH) and analyzes the effects of mispricing on average returns achieved by investor.

Passive Management Strategy

The supporters of the efficient market hypothesis believe that active management is a largely wasted effort and does not support the expenses incurred due to the mispricing of stocks (Barberis and Thaler, 2003).Therefore, they advocate passive investment strategy that makes no possible attempt to beat the market. A passive strategy involves minimum input and instead relies on diversification of the portfolio in order to match the performance of the market index. Passive management is usually characterized by a buy-and-hold strategy because the efficient market theory indicates that stock prices are at fair levels, given all available information and it makes no sense in frequent buying a...

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...his fact is utilized by the investors to plot wining strategies. Furthermore, the evidence from this study suggests that it is not necessary to know predictable patterns and market inefficiency in order to implement profitable investing strategies. Taken together, these results suggest that investors are able to achieve higher returns and minimize transaction cost by adopting indexing strategy which mimics the market. The second major findings are the contrasting view of behavioral finance. Two decades ago, many financial economists supported the Efficient Market Hypothesis because of the forces of arbitrage. Today it can be realized that it was indeed a very naive view and the limits of arbitrage can result in substantial mispricing. Thus through this research it is understood that absence of profitable investment strategy does not infer the absence of mispricing.