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When everyone invests passively...

Posted: Tue Jun 12, 2018 9:27 am
by oriol
Stumbled upon this blog post a few days ago and was wondering what's the Bogleheads' community answer to this particular critique of index investing?

Spoilers:
What's more, the price becomes a lot more driven by cash flows than fundamentals. If the two guys are doing active research and decide the stock is terrible, but the other 8 have incoming cash that they must invest in this stock because its part of the index and there was an inflow of say retirement investments, guess what - there's more buying than selling! So even though fundamental research says the stock should go down, the stock goes up driven by blind demand.
While everyone's more interested in how much they can sell the stock to someone else for, at the end of the chain somewhere someone must be getting revenue from the business, not the "greater fool" to whom they can sell their shares. As investors, we don't think about dividends much because we think about capital gains and the stock price is driven today by tons of factors not related to fundamentals - the fact that a brainless passive strategy is something we even consider talks about how crazy we've gotten with valuations and trading.

Re: When everyone invests passively...

Posted: Tue Jun 12, 2018 9:45 am
by zmaqoptyxbglp
What they're saying is that if more and more people get into indexing, the available alpha in the market will increase. If there were such easy alpha available, people would be able to recognize it and outperform the market for a while, till the "intrinsic value" converges to the market price.

This would mean that tons of active investors would have an easy time consistently beating the market, which there's no evidence for, even now. But say we got to that point. Now more money would move from indexing to active management to get those nicer returns. This will lead to price corrections in the universe that the index captures. But now the universe is once again reasonably priced. So at the end of the day, you can do pretty well just by holding the chosen universe.

That would be my rebuttal.

Re: When everyone invests passively...

Posted: Tue Jun 12, 2018 9:49 am
by Alexa9
Apple is 2.8% of the Total Stock Market Fund. Everyone is buying and reinvesting dividends into Total Stock Market. I can't help but think Apple's price is artificially inflated. Same with other Mega Caps. Still, they're not too big to fail.

Re: When everyone invests passively...

Posted: Tue Jun 12, 2018 9:49 am
by AlohaJoe
oriol wrote:
Tue Jun 12, 2018 9:27 am
Stumbled upon this blog post a few days ago and was wondering what's the Bogleheads' community answer to this particular critique of index investing?
This particular claim has been brought up and debunked repeatedly over the decades. Take your subject -- "when everyone invests passively" -- and type it into the Bogleheads search box. The earliest thread I saw was from 2007, so it has been discussed for 11 years just here on Bogleheads.

Re: When everyone invests passively...

Posted: Tue Jun 12, 2018 9:53 am
by David Jay
zmaqoptyxbglp wrote:
Tue Jun 12, 2018 9:45 am
This would mean that tons of active investors would have an easy time consistently beating the market, which there's no evidence for, even now.
This!

I have said repeatedly (this question comes up again and again on BH) that I, for one, will move back to active stock picking if-and-when there is easily accessible alpha. Because of people like me, this situation ("when everybody invests passively") will never occur.

My test to re-evaluate my passive investment strategy is when active managers of mutual funds can outperform the indexes just 50% the time. According to the SPIVA scorecard, active fund managers outperform their respective indexes only 20% of the time. If the pros can't find easy alpha, I don't believe that I have a realistic chance.

Re: When everyone invests passively...

Posted: Tue Jun 12, 2018 10:53 am
by Call_Me_Op
Question is irrelevant, since this will never happen. The system is self-correcting. As more people index, exploitable inefficiencies increase, which draws investors into active trading

Re: When everyone invests passively...

Posted: Tue Jun 12, 2018 11:24 am
by lawnboss
oriol wrote:
Tue Jun 12, 2018 9:27 am
What's more, the price becomes a lot more driven by cash flows than fundamentals. If the two guys are doing active research and decide the stock is terrible, but the other 8 have incoming cash that they must invest in this stock because its part of the index and there was an inflow of say retirement investments, guess what - there's more buying than selling! So even though fundamental research says the stock should go down, the stock goes up driven by blind demand.
The blind demand from 8 passive investors is causing all of the stocks in the index to go up simultaneously. The two active researchers will depress the price of this particular stock by comparison (i.e. it will go up less). So, while the company's market cap in dollars has gone up, its fraction of the total market cap in the index has gone down. I think this means that a) the stock will under-perform the market average, even if its market cap in dollars has increased; and, b) as the fraction of total market cap declines, the passive indexers will be investing less and less in the company proportionally; this is a feedback that will give the active researchers ever-greater sway over this particular stock's price.

Re: When everyone invests passively...

Posted: Tue Jun 12, 2018 2:44 pm
by Phineas J. Whoopee

Re: When everyone invests passively...

Posted: Wed Jun 13, 2018 12:37 pm
by Tamalak
there's more buying than selling!
Wrong. There's never more buying than selling. There is exactly as much buying as selling.

I'll pass on reading an article with such an obvious error. Back to the drawing board with them.

Re: When everyone invests passively...

Posted: Tue Jun 19, 2018 8:48 pm
by WestUniversity
To me this is somewhat like Vegas. As long as greed drives people to think they can beat the house, those people will keep losing money and providing the capital to keep building those big hotels. That behavior benefits me because I don’t gamble but can enjoy everything else Vegas has to offer.

The same seems to apply with the market. People want to believe there is an investing “secret” or there is a superstar advisor or a “can’t miss” investment. Those people leave investors like me able to take advantage of the “tortoise” that is index investing...

Or it could be the wine I’m drinking talking... Cheers!
:beer

Re: When everyone invests passively...

Posted: Tue Jun 19, 2018 9:27 pm
by k66
WestUniversity wrote:
Tue Jun 19, 2018 8:48 pm
To me this is somewhat like Vegas. As long as greed drives people to think they can beat the house, those people will keep losing money and providing the capital to keep building those big hotels. That behavior benefits me because I don’t gamble but can enjoy everything else Vegas has to offer.

The same seems to apply with the market. People want to believe there is an investing “secret” or there is a superstar advisor or a “can’t miss” investment. Those people leave investors like me able to take advantage of the “tortoise” that is index investing...

Or it could be the wine I’m drinking talking... Cheers!
:beer
No, I think that you got it right. Viva Las Vegas!