Passive investing is a 'chaotic system' that could be dangerous?

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Houe
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Passive investing is a 'chaotic system' that could be dangerous?

Post by Houe » Tue Nov 14, 2017 9:18 am

I'm fairly new to index investing with bogleheads advice. Wondering what your thoughts on this article are...

https://www.cnbc.com/2017/11/14/robert- ... ystem.html

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BolderBoy
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Re: Passive investing is a 'chaotic system' that could be dangerous?

Post by BolderBoy » Tue Nov 14, 2017 9:31 am

Houe wrote:
Tue Nov 14, 2017 9:18 am
I'm fairly new to index investing with bogleheads advice. Wondering what your thoughts on this article are...

https://www.cnbc.com/2017/11/14/robert- ... ystem.html
"The sky is falling, the sky is falling..."

The gurus will be along shortly to comment, but one thing that I'd point out is that index funds are a tool and can be misused. Out of 100 people who "hear" that index funds are nirvana, a largish portion will blindly dump 100% of their investment into an equity index. At some point, the correction comes, they see their investment tank and pull it all out. The effect on the market caused by the folks who bail will be similar to active trading in the short term.
“Where you stand, depends on where you sit” - Rufus Miles | "Never underestimate one's capacity to overestimate one's abilities"

Da5id
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Re: Passive investing is a 'chaotic system' that could be dangerous?

Post by Da5id » Tue Nov 14, 2017 9:39 am

Houe wrote:
Tue Nov 14, 2017 9:18 am
I'm fairly new to index investing with bogleheads advice. Wondering what your thoughts on this article are...

https://www.cnbc.com/2017/11/14/robert- ... ystem.html
Schiller is a smart guy, no doubt about it. But I don't get the issue. If too many people do indexing as a strategy and it makes stock market pricing inefficient, presumably active managers will exploit that in a profitable way and an equilibrium will be reached. Feels like it is self correcting. And while I don't know what percentage of the market needs to be active for pricing to be reasonable, doubt we are there yet. If/when SPIVA shows that active beats passive consistently I'll take notice :)

totesmagotes
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Re: Passive investing is a 'chaotic system' that could be dangerous?

Post by totesmagotes » Tue Nov 14, 2017 10:09 am

Da5id wrote:
Tue Nov 14, 2017 9:39 am
Houe wrote:
Tue Nov 14, 2017 9:18 am
I'm fairly new to index investing with bogleheads advice. Wondering what your thoughts on this article are...

https://www.cnbc.com/2017/11/14/robert- ... ystem.html
Schiller is a smart guy, no doubt about it. But I don't get the issue. If too many people do indexing as a strategy and it makes stock market pricing inefficient, presumably active managers will exploit that in a profitable way and an equilibrium will be reached. Feels like it is self correcting. And while I don't know what percentage of the market needs to be active for pricing to be reasonable, doubt we are there yet. If/when SPIVA shows that active beats passive consistently I'll take notice :)
I partly agree. Part of the reason why markets are efficient in terms of pricing is *because* there are people who speculate one way or another.

I'm in my mid-30s and am just now really in a financial position to start to put money into a retirement account. Almost the entire of my portfolio is in index funds. After reading (well, listening to) a series of great books (The Intelligent Investor, The Four Pillars of Investing, A Random Walk Down Wall Street, The Intelligent Asset Allocator, etc.), the common theme I've arrived at is that (1) index investing is nearly always better than picking individual stocks and, because the market is efficient, (2) no one "strategy" can consistently "beat" the market as a whole since a successful strategy is self-defeating (if it's successful, it gains popularity as more people try the strategy to beat the market, which often removes the advantage of the strategy). However, I wonder why index investing, which is now more popular than ever, is immune to the same fate as the other strategies. Of course, by the nature of index investing, it'll track the market as a whole, but I wonder if the pendulum isn't going to swing so far and if index investing will have a similar fate of so many other previously "successful" investing strategies.

Let's take the logical extreme by looking at a situation in which everyone invests only in index funds. No individual company can out- or under-perform the market as a whole since the index funds just buy or sell stocks according to market cap. So, P/E multiples get thrown out of whack because the stock prices of the well-performing companies cannot rise appropriately and the prices of the poorly performing companies cannot drop appropriately. In other words, the market becomes inefficient. In such an instance, there are fewer equity-driven incentives to perform well as a company, no? I'd think that, in such a market, active mangers and stock pickers could well outperform the index investors, since they (stock pickers / active managers) could overweight the high growth and high dividend payers that become progressively more undervalued. Again, if index investing really does yield the best long-term results, why would it not meet the same fate as other strategies that gain so much popularity that their advantages disappear?

bgf
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Re: Passive investing is a 'chaotic system' that could be dangerous?

Post by bgf » Tue Nov 14, 2017 10:12 am

i recommend you read the series of blog posts on Passive Investing here:

http://www.philosophicaleconomics.com/2016/05/passive/

I think there are 4 of them.

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Re: Passive investing is a 'chaotic system' that could be dangerous?

Post by bertilak » Tue Nov 14, 2017 10:23 am

totesmagotes wrote:
Tue Nov 14, 2017 10:09 am
I partly agree. Part of the reason why markets are efficient in terms of pricing is *because* there are people who speculate one way or another.
No one is suggesting that everyone be required to invest only in index funds. (If they were so required there would be no indexes, or at least no meaningful indexes.)

Whatever market inefficiencies are introduced by index investing will be arbitrated away and that arbitration will be a price-setting mechanism.

Just the opposite, if people were prohibited from index investing things would be worse: The inept stock analysis would introduce errors in price setting. (Of course this already happens, but it would get worse.)

That's my theory and I'm sticking to it!
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Wakefield1
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Re: Passive investing is a 'chaotic system' that could be dangerous?

Post by Wakefield1 » Tue Nov 14, 2017 10:24 am

Slice and dice index funds as ETFs
Trade them in real time all day long,market time between different indexes,portions of indexes
That could get chaotic and could be dangerous!
Is that what drives market volume these days?

trueblueky
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Re: Passive investing is a 'chaotic system' that could be dangerous?

Post by trueblueky » Tue Nov 14, 2017 10:26 am

totesmagotes wrote:
Tue Nov 14, 2017 10:09 am
Da5id wrote:
Tue Nov 14, 2017 9:39 am
Houe wrote:
Tue Nov 14, 2017 9:18 am
I'm fairly new to index investing with bogleheads advice. Wondering what your thoughts on this article are...

https://www.cnbc.com/2017/11/14/robert- ... ystem.html
Schiller is a smart guy, no doubt about it. But I don't get the issue. If too many people do indexing as a strategy and it makes stock market pricing inefficient, presumably active managers will exploit that in a profitable way and an equilibrium will be reached. Feels like it is self correcting. And while I don't know what percentage of the market needs to be active for pricing to be reasonable, doubt we are there yet. If/when SPIVA shows that active beats passive consistently I'll take notice :)
I partly agree. Part of the reason why markets are efficient in terms of pricing is *because* there are people who speculate one way or another.

I'm in my mid-30s and am just now really in a financial position to start to put money into a retirement account. Almost the entire of my portfolio is in index funds. After reading (well, listening to) a series of great books (The Intelligent Investor, The Four Pillars of Investing, A Random Walk Down Wall Street, The Intelligent Asset Allocator, etc.), the common theme I've arrived at is that (1) index investing is nearly always better than picking individual stocks and, because the market is efficient, (2) no one "strategy" can consistently "beat" the market as a whole since a successful strategy is self-defeating (if it's successful, it gains popularity as more people try the strategy to beat the market, which often removes the advantage of the strategy). However, I wonder why index investing, which is now more popular than ever, is immune to the same fate as the other strategies. Of course, by the nature of index investing, it'll track the market as a whole, but I wonder if the pendulum isn't going to swing so far and if index investing will have a similar fate of so many other previously "successful" investing strategies.

Let's take the logical extreme by looking at a situation in which everyone invests only in index funds. No individual company can out- or under-perform the market as a whole since the index funds just buy or sell stocks according to market cap. So, P/E multiples get thrown out of whack because the stock prices of the well-performing companies cannot rise appropriately and the prices of the poorly performing companies cannot drop appropriately. In other words, the market becomes inefficient. In such an instance, there are fewer equity-driven incentives to perform well as a company, no? I'd think that, in such a market, active mangers and stock pickers could well outperform the index investors, since they (stock pickers / active managers) could overweight the high growth and high dividend payers that become progressively more undervalued. Again, if index investing really does yield the best long-term results, why would it not meet the same fate as other strategies that gain so much popularity that their advantages disappear?
As soon as the smart active people see an opportunity and buy, that drives the price up, assuming they can find smart active people willing to sell. Equilibrium achieved. And the index reflects it without my having to do anything.

I think the problem areas are in some of the small niche indices, Balkan value index, for instance. Large, well-known indices (Dow, EAFE) should not face the same issues.

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rustymutt
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Re: Passive investing is a 'chaotic system' that could be dangerous?

Post by rustymutt » Tue Nov 14, 2017 10:38 am

This argument about passive or active is ridiculous from my advantage. The very best, can't out gain the indexes consistently, and this has been shown over, and over again. And when they do, they don't stay on top long. Just look back at the history of this. Permanently passive, and glad for it. I know I can't beat the indexes in choosing funds, or stocks. But I have beat the S&P 500 many times, because of the diversification, and simplistic approach to investing in my portfolio.
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avalpert
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Re: Passive investing is a 'chaotic system' that could be dangerous?

Post by avalpert » Tue Nov 14, 2017 10:38 am

totesmagotes wrote:
Tue Nov 14, 2017 10:09 am
Da5id wrote:
Tue Nov 14, 2017 9:39 am
Houe wrote:
Tue Nov 14, 2017 9:18 am
I'm fairly new to index investing with bogleheads advice. Wondering what your thoughts on this article are...

https://www.cnbc.com/2017/11/14/robert- ... ystem.html
Schiller is a smart guy, no doubt about it. But I don't get the issue. If too many people do indexing as a strategy and it makes stock market pricing inefficient, presumably active managers will exploit that in a profitable way and an equilibrium will be reached. Feels like it is self correcting. And while I don't know what percentage of the market needs to be active for pricing to be reasonable, doubt we are there yet. If/when SPIVA shows that active beats passive consistently I'll take notice :)
I partly agree. Part of the reason why markets are efficient in terms of pricing is *because* there are people who speculate one way or another.

I'm in my mid-30s and am just now really in a financial position to start to put money into a retirement account. Almost the entire of my portfolio is in index funds. After reading (well, listening to) a series of great books (The Intelligent Investor, The Four Pillars of Investing, A Random Walk Down Wall Street, The Intelligent Asset Allocator, etc.), the common theme I've arrived at is that (1) index investing is nearly always better than picking individual stocks and, because the market is efficient, (2) no one "strategy" can consistently "beat" the market as a whole since a successful strategy is self-defeating (if it's successful, it gains popularity as more people try the strategy to beat the market, which often removes the advantage of the strategy). However, I wonder why index investing, which is now more popular than ever, is immune to the same fate as the other strategies.
It isn't immune, and it doesn't claim to be. Nobody thinks (or at least nobody with a basic understanding thinks) that a broad index strategy can consistently beat the market - or beat it at all. The strategy is explicitly not trying to. It can however, as any other strategy can, match the market before costs.

The root assumptions of these 'arguments' are a red herring - index funds can't beat the market in the long run and if it were trying to it would be arbitraged away to the point that index funds match the market, but of course that is all the index fund investor (ought to) believe they are going to get.

Beyond that, this whining angle of attack on passive investing is getting old.

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bertilak
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Re: Passive investing is a 'chaotic system' that could be dangerous?

Post by bertilak » Tue Nov 14, 2017 10:43 am

avalpert wrote:
Tue Nov 14, 2017 10:38 am
Beyond that, this whining angle of attack on passive investing is getting old.
Even if it was all TRUE, why is it my responsibility to regulate the markets? Even if it WAS my responsibility I'm sure I would be really bad at it and mess things up, so leave me out of it.
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Re: Passive investing is a 'chaotic system' that could be dangerous?

Post by oldcomputerguy » Tue Nov 14, 2017 10:47 am

avalpert wrote:
Tue Nov 14, 2017 10:38 am
It isn't immune, and it doesn't claim to be. Nobody thinks (or at least nobody with a basic understanding thinks) that a broad index strategy can consistently beat the market - or beat it at all. The strategy is explicitly not trying to. It can however, as any other strategy can, match the market before costs.
In fact I'd say that passive broad-market investing in a total-market fund can and by definition does match the market before costs.
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avalpert
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Re: Passive investing is a 'chaotic system' that could be dangerous?

Post by avalpert » Tue Nov 14, 2017 10:52 am

oldcomputerguy wrote:
Tue Nov 14, 2017 10:47 am
avalpert wrote:
Tue Nov 14, 2017 10:38 am
It isn't immune, and it doesn't claim to be. Nobody thinks (or at least nobody with a basic understanding thinks) that a broad index strategy can consistently beat the market - or beat it at all. The strategy is explicitly not trying to. It can however, as any other strategy can, match the market before costs.
In fact I'd say that passive broad-market investing in a total-market fund can and by definition does match the market before costs.
I wouldn't go quite that far to say it by definition does - index funds have to be operated in a way to match the performance of the index it is tracking and that is not a trivial exercise. This is why you want to monitor how well the fund actually tracks its index and would like to see it track almost exactly once accounting for costs (including securities lending). A given attempt at a total-market fund can fail to match the market, if it is failing on the high side for an extended period you should assume it is because it is taking on more risk and that will eventually come back to bite them.
Last edited by avalpert on Tue Nov 14, 2017 11:55 am, edited 1 time in total.

Tallis
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Re: Passive investing is a 'chaotic system' that could be dangerous?

Post by Tallis » Tue Nov 14, 2017 11:06 am

bertilak wrote:
Tue Nov 14, 2017 10:43 am
avalpert wrote:
Tue Nov 14, 2017 10:38 am
Beyond that, this whining angle of attack on passive investing is getting old.
Even if it was all TRUE, why is it my responsibility to regulate the markets? Even if it WAS my responsibility I'm sure I would be really bad at it and mess things up, so leave me out of it.
Ain't that the truth. I'm perfectly happy to let these smart people on CNBC snap up the profits I'm supposedly leaving on the table.

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Re: Passive investing is a 'chaotic system' that could be dangerous?

Post by jhfenton » Tue Nov 14, 2017 11:19 am

I'm going to give Shiller the benefit of the doubt and assume that CNBC's headline is inflammatory and his quote pulled out of context, because the implication of the headline and quote is completely asinine.

Expro
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Re: Passive investing is a 'chaotic system' that could be dangerous?

Post by Expro » Tue Nov 14, 2017 3:06 pm

Schiller refers to economic free riding. Indexing is a form of free riding. When you buy an index you don't participate in making the market. Your buy decision is based only on the index's value - assuming you're even making a decision to buy on the index's price and not just automatically investing on the 15th every month . Your purchase has no effect on the market's price discovery.

And as more and more buying is done absent any price discovery - any market making - you'll get less efficiency with less volatility.

Is that market chaos? Maybe Schiller is referring to economic chaos theory?

Maybe market anti-anarchy is a better phrase.

It's interesting to consider but the market still moves everyday. But volatility is trending down, I've heard.
Maybe this bull market has pple looking for something else to worry and talk about when they don't want to mention the word bear?
Last edited by Expro on Tue Nov 14, 2017 3:20 pm, edited 1 time in total.


avalpert
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Re: Passive investing is a 'chaotic system' that could be dangerous?

Post by avalpert » Tue Nov 14, 2017 3:21 pm

Expro wrote:
Tue Nov 14, 2017 3:06 pm
Schiller refers to economic free riding. Indexing is a form of free riding. When you buy an index you don't participate in making the market.
To believe that you have to believe that any use of a market order is free riding. And even then it makes no sense - you are participating in making the market by providing liquidity to the market. You pay all the costs associated with participating in the market, while you may not be paying for additional research people can actively choose prices without paying for active research too (and many individual investors do just that) - you aren't free riding on the people paying to research and coming to opposite conclusions (one buying and one selling at the same price) you are accepting the outcome their attempts to outguess each other brings.

Since even index fund investors cannot buy a security or sell one without a willing counter party agreeing to the price received I don't see any way it meets the actual definition of 'free riding' as used in economics. More whining really.

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Re: Passive investing is a 'chaotic system' that could be dangerous?

Post by TropikThunder » Tue Nov 14, 2017 3:29 pm

totesmagotes wrote:
Tue Nov 14, 2017 10:09 am
Let's take the logical extreme by looking at a situation in which everyone invests only in index funds. No individual company can out- or under-perform the market as a whole since the index funds just buy or sell stocks according to market cap. So, P/E multiples get thrown out of whack because the stock prices of the well-performing companies cannot rise appropriately and the prices of the poorly performing companies cannot drop appropriately.
The entire stock market system would cease to exist in this "logical extreme." If no one traded individual stocks ("everyone invests only in index funds" then NO publicly traded company would ever be able to determine stock price, hence no market cap, no P/E ratio, no index in the first place.

totesmagotes wrote:
Tue Nov 14, 2017 10:09 am
Again, if index investing really does yield the best long-term results, why would it not meet the same fate as other strategies that gain so much popularity that their advantages disappear?
Precisely because indexing does not seek to beat the market. Other popular strategies are judged as successes or failures based on their performance relative to the broader market. When that advantage goes away (like from performance chasing), that strategy starts to underperform (or at least no longer outperform). With indexing, there was never a goal to outperform the market in the first place, hence no outperformance to vanish. My goal is to achieve the index performance, and every year I receive the index performance. I don't see an opportunity for this to fail (absent costs).

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Re: Passive investing is a 'chaotic system' that could be dangerous?

Post by CULater » Tue Nov 14, 2017 3:46 pm

“The problem is that if you are talking about passive indexing, that is something that is really free-riding on other people’s work,” he said. “So people say, ‘I’m not going to try to beat the market. The market is all-knowing.’ But how in the world can the market be all-knowing, if nobody is trying — well, not as many people — are trying to beat it?”

“It’s kind of pseudoscience to think these indexes are perfect, and all I need is some kind of computer model instead of thinking about business,” he (Shiller) told CNBC.
Have to admit that I've often thought it seems cosmically unjustified to be able to make money without really doing anything or knowing anything. But I guess that's the story of my life...
May you have the hindsight to know where you've been, The foresight to know where you're going, And the insight to know when you've gone too far. ~ Irish Blessing

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Re: Passive investing is a 'chaotic system' that could be dangerous?

Post by asset_chaos » Tue Nov 14, 2017 5:00 pm

I just started a thread here viewtopic.php?f=10&t=232300 on an article from the Economist that could have been written as a rebuttal to some of the gripes in Schiller's interview. And there are several other threads debunking this kinds of complaints about index funds.
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