Bogleheads

[Indexer88]

More and more people are seeing the futility of trying to time the market or to beat the market. More and more individuals and funds are moving to indexing. I think it's substantial now. As they show positive gains, and more and more move in, what are some of the long-term consequences? The first question I have is: Who will set prices? If the market is moving to passive investment, then a shrinking number of active managers are the only ones who will set pricing. Are index funds ultimately dependent upon averaging active managers and doesn't this lead to an ever larger herd following an ever decreasing set of leaders? And eventually won't the decisions of those few de facto become what is followed by the passive pack of indexers?

Hedge funds are still a large industry: 1.4 trillion. They can force the market up, and when individuals buy into index funds they have to pay prices inflated by hedge fund speculation. Should we partially time the market in the sense of avoiding bubbles caused by these funds?

Some investors/hedge funds do not have to worry about the 1.5% ER as they invest directly. Isn't there a role for investment banking, hedge funds and venture capital still?

Of course, it's an extremely competitive world and almost all individual investors are better in an index. But can an index fund even exist in a world without speculators, without those trying to beat the index? And is there some point at which indexing becomes so dominant, that it becomes more likely that people outside the herd can beat such enormous passivity? Is the individual still best served by index funds?

[tadamsmar]

[simplesimon]

Question by noob investor in April 2008

[wj]

Whatever, investments would still be subjected to the business cycle and there will still be boom and bust.

So, it is still important to take some money off the table when you think market is in a bubble ..and wait for reinvestment opportunity.

We do not need to know the exact bottom nor the exact top.

[larryswedroe]

your post is the title of Story 21 in Wise Investing Made Simple, Check it out if interested

[drbagel]

[TheEternalVortex]

Presumably if too many people start indexing, then prices will become inefficient, so some people will stop indexing as they realize this.

[larryswedroe]

erternalvortex

What is important to understand is that while the market might become less INFORMATIONALLY efficient if there was less trading, that doesn't change the arithmetic of active investing (Sharpe's "Law"). Active investors as a group must underperform passive investors simply because they have higher costs.

Also it is important to understand that as you get less trading you have less liquidity and bid offer spreads widen and market impact costs rise. So that would offset any informational advantage.

Just think of it this way--small caps are less informationally efficient than large caps and EM less informationally efficient than developed markets but the same findings on active vs passive hold. The majority of active investors lose to the market and there is no persistent outperformance beyond the randomly expected.

[inve$t0r]

I asked the same question a few years ago in M* Vanguard Diehards. Larry Swedroe answered back then too with a similar answer. I have a degree in Economics yet I still don't understand these explanations. Like the OP, I think that if most stopped trading, prices will be set by the few that do and markets will become unstable, then indexers will be forced to start trading. I'm also worried that markets are increasingly dominated by large mutual funds, and the potential for corruption and the malfeasance we’ve been witnessing.

[raddle]

Interesting point, but I don't think it takes a very large active percentage of the market for prices to be reasonably efficient. I probably grossly oversimplify things, but I always imagined that there were a select group of 'insiders' who have the ability to trade without commissions whose trading is sufficient to price the market. Don't the brokers just pay commission to themselves?

[bearwolf]

[deepdrive]

There will always be a ton of money in actively managed funds because:

1. 401(k)s
2. Greed
3. Ignorance
_________________
Investment difficulty and long-term success are perfectly negatively correlated. Keep it simple.

[taxman]

[DiscoBunny1979]

[deepdrive]

DiscoBunny,

I think greed and ignorance sums up what you wrote.

So, what do you mean, "Not quite?"
_________________
Investment difficulty and long-term success are perfectly negatively correlated. Keep it simple.

[DiscoBunny1979]

[deepdrive]

Wanting to do well in school - ambition
Driving a highly rated car - smart, if for reliability and practicality reasons
Getting plastic surgery to look better - vanity

Wanting to beat the stock market - greed
Thinking you could do it - ignorance

I stand by what I said.
_________________
Investment difficulty and long-term success are perfectly negatively correlated. Keep it simple.

[DSInvestor]

We are a country of excesses. Consider the powerball lottery which can grow to hundreds of millions of dollars to a single winner. Isn't this overkill? Why not adopt a system like Spain where hundreds of people can share the top prize? What American wouldn't like to have a 1/100th share of $300M or 1/1000th share of $300M. I would argue that 300K would be a life changing event for most Americans. However, it doesn't sell papers and tv air time like see a Regular Joe or Jane picking up a $150M lump sum check. We Americans want it all, and would probably vote down a measure to convert lotteries to multi-winner format.

John Bogle is a rare man who not only made indexing available to the individual investor, he also made us the owners of the company and as owners, we get the portfolio management services at cost. This ownership structure has cost him billions, but he has enough.

[deepdrive]

DS,

That Bogle quote is outstanding. I am going to have to tell that to some friends and family.
_________________
Investment difficulty and long-term success are perfectly negatively correlated. Keep it simple.

[simplesimon]

Isn't that the prologue to Bogle's new book Enough. that I should be receiving today?

[Indexer88]

Dimensional Funds has a discussion of this question under Library then FAQ:

www.dfaus.com.

They quote Vanguard funds at about 200 billion in 2001. I think it's now about one trillion under management, not all indexed.

One source of pricing would be corporate officers and corporations themselves buying their own shares or owning those of other companies. However, this could itself be gamed.

My question is a "theoretical" one with extremely long term implications. I think indexing will be the way to go for the next 10 years, at least. But I think we might see the future with a problem that occurs with indexing when a stock enters the S&P 500. Those stocks will be bought by many S&P 500 index funds, and so speculators buy possibilities ahead of time, or the day of announcement. Funds have ways around this, for example, not buying until the price stabilizes. But this is an example of how active investing beats passive. Speculators can take advantage of the passive investment style of index funds, in effect, at the cost of those index funds. Since the S&P 500 is fairly fluid over the decades, this may be a larger problem then we might think, and might be getting worse. A TSM fund might avoid this problem. But there probably is a similar one at the micro-cap level.

One positive of a market owned by a high percentage of index funds might be lessened volatility. Even when a stock goes up or down, it keeps its relative performance in the fund, so there's no need for the fund to buy or sell shares.

It seems it's primarily a matter of when a stock enters or leaves an index that there is a problem. When a stock leaves the S&P 500, it might be oversold during that process, only to rebound later. There's volatility at the margins of index funds that could be taken advantage of by active managers.

[malloc]

My hope is that when there are enough "investors" in index funds (as opposed to short term speculators), these index funds will provide an increasingly loud voice demanding long term accountability and oversight of the management.

I understand that PERS, for example, is active in demanding perfomance of management.
I hope they have lots of company in the future.

[drjdpowell]

[market timer]

[ttcbj]

This question comes up repeatedly. I still think the best answer is Warren Buffett's 2005 essay, "How to Minimize Investment Returns." You can search for it in Google. It starts by imagining a world where everyone owns an index fund (essentially), and then imagines how the world changes as more trading is introduced. The answer is: investors retain less and less of the profits produced by the businesses.

Buffett's essay was also paraphrased in Bogle's book, "The Little Book of Common Sense Investing".

The key insight of the essay, the key insight in answering your question, and I think they key insight in all investing, is that you need to think of yourself as investing in the underlying businesses (even if you are using an index fund to super-diversify).

If everyone owned a single index fund, their returns would be driven almost exclusively by the underlying dividends the businesses paid, and by the increase in earning power of the businesses over time. If a business is paying you a solid dividend and/or growing its earnings rapidly (which creates the expectation of future dividends), you don't need a market to quote you a price in order for it to have value. You just need to wait to receive your dividends. Trading stocks does not increase the intrinsic value of the earnings/dividends produced by real businesses. In aggregate, the maximum amount investors can earn from their investments is the earnings/dividends produce by the businesses. All trading beyond that may only redistribute the earnings from one investor to another, or degrade the earnings through fictional costs.

[LH]

I was wondering this same question myself. Recent events in this market downturn have convinced me there is near zero risk to everyone indexing.......

The posts even on this board have swung to some active management, people saying its a good time to go into this or that(getting back in to REITS springs to mind).

Even top notch bogleheads seem to do some sort of "Boglehead plus" whether it be TIP sliding scale purchases or whatever.

Multiple posts about other strats rather than Boglehead.....

Multiple posts about people "screwing up" thier risk estimate, and posts saying its ok if you screwed up to "readjust" (ie to buy high and sell stocks low during a downturn).

So yeah, a bunch of good reasons to "readjust" or whatever. Nice sounding rational reasons. Just like the stock market, where one human has his list of reasons he is selling, and the other human has his list of reasons why he is buying the same stock. Both are beautiful, and sound logical.

That is human nature. Heck it may even be right. I mean the experts on here, who know more than me, say its fine to readjust during a downturn (buy high and sell low again is the equivalent, but bogleheads have better reasons, its reevaluating your risk and need etc).

So anyway, once you get out of all this effective buy high sell low behavoir, this failure to stay the course, Some just mere human behavorial bad buy high and sell low, and other more "enlightened" Boglehead buy high and sell low due to whatever the good sounding reasons are, You are left with very few humans who make it through, even hard core bogleheads, who eat and breath this stuff on the forumn.......

The ENTIRE brokerage industry is dead set against it. The money magazines are dead set against it, the CNBC show, Cramer, Mad money are against it........

So you got basic elemental human nature, the flawed human brain, pristine and proper and TRUE by Boglehead reasons to not buy and hold, er I mean to readjust, and a HUGE industry all going against buy and hold......

Heh, no worries anymore to me. Humans are not going to spontaneously all buy and hold passive index funds, anymore than they are going to quit gambling or breathing. Buy high, sell low is ingrained in our nature, for all the right reasons.

[Karl]