November 09, 2010
Arbitrariness and the Social Contract
Posted by Jeff Schwartz

In my last post, I talked about the arbitrariness that pervades both passive and active investing.  Today, I’ll talk about why we might care about this as a policy matter.

For one, the arbitrary nature of investing potentially poses fairness concerns.  Intuitively, it seems unjust that some should be rewarded by chance market moves while others are victims. 

This intuition can be fleshed out by appealing to Rawls’s notion of the veil of ignorance.  Behind this veil, those drafting the social contract do not know whether those whom they represent will be fortunate or unfortunate.  As such, he posits that these individuals would design society so that those who benefit from morally arbitrary good fortune, such as being born with high intelligence or to a wealthy family, share with those who are less lucky. 

This notion of egalitarianism can be applied to stock-market investing.  As discussed last time, to a great extent, stock-market gains and losses similarly represent morally arbitrary good and ill fortune.  Therefore, it seems that society would benefit to the extent that the chance gains and losses the market conveys are equitably distributed.  This line of thinking seems to have particular merit in the retirement context, where an intuitive conception of what is just tells us that the amount of one’s contributions rather than arbitrary market swings should determine the balance of one’s retirement account. 

Government intervention to effectuate the sharing of chance market returns, particularly in connection with retirement savings, may, therefore, be justified based on fairness grounds.

The arbitrariness also seems to suggest that the allocation of resources to actively managed mutual funds is inefficient.  Welfare economics tells us that we want resources to flow to their best use.  If returns that result from stock-picking are largely the result of chance, then expending resources in this pursuit may not be justified.  Why would we expend resources to arbitrarily distribute wealth?  This concern seems particularly poignant when one considers that market trading is zero sum in the sense that for every trader who bets correctly there is a counterparty who is not so fortunate.  Thus, chance gains and losses are simply reshuffled among investors without any moral claim to them, while fund managers extract fees for their efforts.

The above may overstate the case against active mutual fund management.  Some benefits do accrue to investors in the form of more accurate stock prices and a more liquid market.  Nevertheless, it seems probable that society is spending too much on the search for market-beating returns.  Thus, some type of regulatory intervention may be justified.

In my next post, I’ll talk about some potential responses to the fairness and efficiency concerns raised by the arbitrariness of the stock market.

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