If Everybody Indexed, Would It Stop Working?

2013 April 29
by Kyle Bumpus
from → Investing And Investments

It’s difficult to get into an “active vs passive investing” discussion on the internet without somebody throwing out the “yeah, but if everybody indexed it would stop working” argument. Yeah, that’s true. But that’s also true of just about everything, everywhere.  If everybody invested in real estate, there’d be no renters. If everybody was an electrician, there’d be no plumbing, etc. You’re not everybody and shouldn’t invest as though you are. Is there currently an advantage to preferring index funds to actively managed funds? Yes, there is. Might this advantage disappear in the future? Possibly. But until it does…

Here’s Why “Everybody” Will Never Index

The aforementioned objection is stupid for a lot of reason, but let’s take a moment to think about why it will never be an issue in the real world.

  1. The market is inherently efficient – The public stock and bond markets are extraordinarily efficient, which is what makes indexing such a smart strategy to begin with. But what if everybody suddenly started indexing tomorrow. What would happen? Huge pricing errors would quickly arise. Eventually, these pricing errors would grow so large that even investors of modest skill would be able to profit from active management without much effort. Once that happened the pendulum would swing in the opposite direction and everybody would become an active investor because it would be, by far, the most profitable thing to do.
  2. People are greedy – Unless you believe people will knowingly avoid acting on what they believe to be easy profit opportunities for long periods of time, you’ll never have to worry about the pricing errors mentioned in item #1 above going unexploited for long. If I see $100 on the ground in front of me, I’m going to pick it up. Likewise, if some mutual fund manager sees an obvious mis-pricing, she’s going to act on it. It’s what she’s paid to do, after all.
  3. Prices are set at the margin – Market prices are set at the margin, which means the market only requires a relatively small percentage of investors to be actively trading in order to remain efficient. The market doesn’t need 95% of market participants to be active in order to set prices accurately. It can get by on much less. What’s the real number? I have no idea, but I’m going to wildly speculate that it’s probably around 50%. I very much doubt indexing will ever comprise anywhere near 50% of the market. Fama and French actually wrote a paper on the topic. Their conclusion? It depends on who goes passive. Not very helpful, I’m afraid.
  4. Stock picking is fun – Passive investing is horribly boring. I would know: I have to find a way to write about it on a weekly basis.
  5. Passive indexers are poor owners – There is a class of investor out there, called activist investors, whose raison d’être is to unlock shareholder value by provoking management to take actions they otherwise wouldn’t be apt to take. In other words, they attempt to stir the pot for their own benefit. You can’t do that via an index fund. Corporate governance fanatics, likewise, find index investing to be untenable. Unless those types of investors disappear, indexing will never take over completely.
  6. Most people don’t care and would rather just have somebody else do it – The vast majority of people just don’t care enough to learn about investing in general and indexing in particular. Those people will continue employing active managers because intuitively, active managers should be able to add value. That they don’t will go unnoticed. I don’t see this ever changing.

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2 Responses
  1. 2013 May 3

    Indeed, if everyone jumped off a cliff, the funeral homes’ profits would go through the roof, but only if those in the funeral biz refrained from jumping.

    Indexing is remarkably successful, as you know. Study after study shows that the pros don’t beat the indexes, so the average funds lag the index by at least their expense ratio. We go from an average S&P return of 10% to 9% for those in funds, to under 5% for the typical investor who dives in on the rising market and sells right at the bottom. Studies from Dalbar support how much the individual tends to lag.

    The stock picking is tough to avoid, it really is fun. And you only need to be really right now and then. One Apple, up 40 fold will make up for a dozen or more bad picks. But I’ll be the first to admit, the great picks aside, over time I’m still happy to trail the S&P by .06%.

  2. 2013 November 24

    Its certainly a nice question to ponder on. Bottom line, it won’t be happening any time soon despite the massive awareness created by gurus, experts and tv talk-heads. Greed still rules and for most people, that boils down to hiring renowned fund managers or doing it on their own. In a way, the market has a keen sense of self-correction and preservation.
    Till I can find a magic ball to help me predict the future, index investing is the way to go!

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