Index Investing
One of the first arguments I remember reading about investing in stocks, that made sense, was that it's basically investing in businesses, with the expectation that those businesses you selected would do well and, as a consequence, the stocks would go up. For this to happen, this selection process has to be accurate, both in making sure that the businesses are actually sound, their future prospects for growth are good, and the price they are being offered to you are not so high that you will not make a profit even if the first two factors are true.
This is obviously very hard to do, few people can, and even the so called professionals fail as much as they succeed. Markets are just too efficient, and the game is too tough to beat. So comes indexing: you refrain from trying to beat the game, a game so hard that it's almost impossible to be beaten by an average joe anyway, and accept the average less fees to not run the risk of actually doing worse.
From what I understand, index investing is in fact mainstream nowadays, in the United States at least, and I wouldn't be surprised if that's what the majority of individual investors are doing. That's the usual advice you get even from legends like Warren Buffett, who went as far as making a bet that active managed investment funds selected by professionals wouldn't beat passive investing (and he won).
The S&P500 seems to have made 5.99% CAGR from 1928 up to now (I believe this doesn't include dividends, but not sure, and 1928 was chosen only because it's the year candlestick data became available on tradingview, so more or less randomly, although I know what happened just a year later haha). I understand that this performance was accomplished, by the most part, via investors analyzing, buying and selling stocks, thus it's a fair assessment of how much the (market weighted) average major american business did over the same period.
Now, if everyone, or most of the market, consciously abandon the pursuit of stock picking, with its own risks, for the safety of the average, wouldn't this create a price insensitive market where big businesses, with the odd bubble business like AI mixed in between, will randomly go up or down according only to how much money there is circulating in the economy, with no other regard to how well the underlying businesses are doing? And obviously, any business no matter how well it does, if it's not in the index, will have its stock perform poorly and being neglected.
Isn't the whole indexing thing making the market, on average, more inefficient, with this inefficiency becoming exacerbated the more the trend keeps going up? Can we really expect that market to perform as it did historically, if investors stop analyzing individual businesses, and the market stops being a consensus of how everyone prices everything? Not sure how this would end, but looks like a self defeating trend to me in the long run.
5 Replies
I think the main reason professionals fail to beat the index is it's their job to market whatever fund they are selling and then to wreck their clients with fees.
For example, if you are Ray Dalio over at Bridgewater and you walk into his office and say hey the market is way overvalued here maybe we should liquidate he will laugh you out the door.
His job is to buy stocks that will never go broke Coca Cola, Microsoft, Apple, blah blah blah and then to charge you a fee. So they end up with a result similar or worse than the DOW, because they have expenses like marketing, rent, employee payroll, litigation etc.
People think the pros have an edge over the little guy but it's the opposite.
The markets definitely aren't efficient and can be beaten.
For example 01 Oct 21 Netflix shares were 700 six months later they were 174.
So they are worth 700 or 174? You tell me.
It's the professionals job not to lose, not to get sued, to own a basket of stocks with low risk and to charge a fee, so they will never beat the index.
Index funds and ETFs own only about 16% of the US stock market. The majority of assets are still managed by active funds and other investors, so price discovery still exists.
That being said in a bull market I do think it favors the likes of Apple and Microsoft, which is probably a reason why they trade at very fancy prices, but when there is a bear market obviously the opposite starts happening, instead of people buying those stocks through the ETFs they are selling.
I think I read a quote on Peter Lynch's book that said something like this (my words): fund managers as a whole fail to beat the market because they either don't want, can't, or both, take risks investing in less known companies (I don't remember if he mentioned this but it seems obvious that size (how many $ you have) matters a lot on this too), so they end up all investing in pretty much the same stocks, which end up being companies in the S&P 500 basically. Lack of creativity and risk taking. Unwillingness to stand out if things go south.
I still think it's a very difficult game to beat for sure, but I can also definitely see that fund managers would rather stay relatively close to the index and achieve the same mediocre performance of everyone else, and end up with a job and his fees and getting rich at the expense of his investors doing worse than the index.
When the alternative is take risks trying to be a superstar, failing and losing your job.
Index funds and ETFs own only about 16% of the US stock market. The majority of assets are still managed by active funds and other investors, so price discovery still exists.
That being said in a bull market I do think it favors the likes of Apple and Microsoft, which is probably a reason why they tr
Thanks, I thought it was higher than 16%. 😀
Outside of Warren Buffett Peter Lynch is the investor that I respect the most and he's right about what you just said.
The only negative thing that I would have to say in relation to Peter Lynch and the Magellan Fund is that when he experienced his extraordinary results it was the greatest period in history for stocks.
The prior decade before he came along the stock market was in a horrific decade long bear market mired by stagfation.
When Peter Lynch started the S and P 500 had like a 10 PE or something crazy like that.
But, he is an incredibly bright and admirable guy. I like him a lot.
