Applying the Efficient Market Theory

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Applying the Efficient Market Theory

Mutual funds that invest in the securities of a market index are called index funds. Index investors don’t try to pick winners and losers. This approach is called passive investing, and it reflects the efficient market belief that you can’t beat the market. Instead, index funds attempt only to duplicate average market returns by investing in and holding onto a selection of market index securities. In other words, if you can’t beat the market, join it.

How index funds help

By investing in several indexes, index funds can reach average market returns regardless of a few holdings that underperform the market. Because index funds do not actively trade their securities to try to outperform the market, they typically have lower transaction costs and management fees than other mutual funds. In an efficient market, it’s useless to pay these extra costs to try to beat the market. It can only reduce your returns.

How index funds see the market

Index funds, like the efficient market theory itself, are based on the belief that because investors themselves are the market, there is no way to outperform the market. Therefore, the typical investing costs spent by a mutual fund to beat the market actually cause the fund to underperform the market by the amount of these costs.