TaketheFifth 73Strategies
You might as kwhether it is worth your time to do hardheaded anal-
ysis of business or whether you would be better off letting other
people do the wor kand then free riding on their effort. Economists
illustrate this free rider strategy by positing a country that taxes its
citizens in order to build a good military. Everyone agrees that this
is desirable to defend against foreign enemies. A tax dodger free rides
on the public good of a strong military while not contributing to it.
Is it possible for an investor to let others do the investment re-
search (pay the taxes) yet participate as a free rider in the market
anyway? Not quite. First, in the classic free rider example, there are
two classes of people: those who pay their taxes and those who free
ride. In stoc kinvesting, there are three: those who do their home-
work, those who speculate, and those who free ride. The addition of
the speculators makes it possible for those who would otherwise be
content with a free ride to exploit the folly of the speculators by
doing their homework.
You might ask, If those doing the homework can gain so much
from the speculators, why doesn’t everyone shift from speculating to
homework? Good question. People should. But they don’t. Ben Gra-
ham and Warren Buffett—the consummate homewor kdevotees—
repeatedly marvel at the inertia of speculators and can only wonder
why so many people choose lemming-like laziness over active anal-
ysis. Yet the speculator is here to stay, as the trends identified earlier
suggest (and not everyone will read or heed this book). Plus c ̧a
change, plus c ̧a la meˆme chose.
Even the strategies that come closest to resembling the free rider
gambit require some work. The most common version of a free rider
strategy, which may be best for many people, is long-term investment
in an index fund. An index fund is a mutual fund that buys the same
securities that are in a given index, such as the S&P 500. They have
grown to gigantic proportions of total invested capital.^4
People are attracted to such funds for lots of reasons. For one
thing, the S&P 500 and similar indexes consistently outperform the
managers of active portfolio funds. Indexes also change relatively
little, and so index funds have low stoc kturnover and therefore lower
costs and better management of taxable gains.
The chief potential downside of indexing is that it pays no at-
tention to fundamentals, emphasizing past returns rather than eval-
uating future prospects. The trade-off hinges on an investor’s ability