What happens when everyone is using index funds?

[RetireBy90]

I've been thinking lately, what happens when everyone is using index funds. All the "wisdom" I've read from those with more experience, it seems that a rule is that once a rule is accepted by all it doesn't work any more. Just trying to think this through.

If say Northern Widget Co and Southern Widget inc both in the same business and with the same sales and profits, say both sell for $10/share.

Now lets further say Southern Widget inc gets into a new line of business and they double earnings per share and Northern Widget Co doesn't change, then one share of Southern should be worth $20 and Northern would still be worth $10. However, index funds don't buy and sell based on earnings, they hold the entire market. Who is left to push up Southern closer to share price of $20 ?

Does this not mean that as index funds gather a greater portion of investments, potential rewards are even greater for those willing to buy based on earnings or other valuation metrics? If shares of Southern say go to say $15 that would mean a greater value than Northern at $10. Right ?

I'm currently using index funds where I can (my 401K doesn't have index funds for many categories) with a small portion in individual stocks so I'm a believer in index funds, but if we keep going with greater and greater portion of investments going to index funds, I'm trying to be open minded about the selection of index funds at some point. It may end up being a generation away or more. My parents grew up when mutual funds were just becoming popular and all had sales charges. Then we got no load funds, and now we have index funds. Each of these were great at the time they came out, but have been supplanted by the next.

Just thinking out here - anyone else have similar discussions with your self?

 

[athena53]

Jim Cramer has made that point- that by careful stock selection you can do better than just buying the index or the ETF for a sector of the market.


I've got a big mix of investments- probably more complicated than it needs to be- and am gradually shifting to Index funds and ETFs. I'm watching my individual stocks, though, and they're outperforming the indices. I don't think I'll ever get out of individual stocks but I'm getting less tolerant of mutual funds that pretty much track the relevant indices.

 

[Big_Hitter]

Who is left to push up Southern closer to share price of $20 ?

you will still have investors buying and selling individual stocks (consider large pension fund managers, for example) - that would be an arbitrage opportunity that would quickly correct itself

 

[Big_Hitter]

Jim Cramer has made that point- that by careful stock selection you can do better than just buying the index or the ETF for a sector of the market.

every time I'm in the gym and he's squawking on TV I wonder how much money he's lost in the market - if he was so good at picking stocks he wouldn't be on TV


wasn't he the one that was publically touting beat sterns as a strong buy then they went under two days later?


looks like he has zero credentials - he's just a journalist - http://www.nerdwallet.com/blog/inve...m-cramer-thestreetcom-founder-mad-money-host/

 

[MichaelB]

Just thinking out here - anyone else have similar discussions with your self?

Research Affiliates has done lots of research looking at building indices based on other valuation methods instead of revenue. RAFI Fundamental Index

 

[Texas Proud]

It will NEVER happen...

First, there are a lot of people who just do not know what to do and listen to a FA.... they do not put people in index funds (much)...

Second, there are always going to be people who think they are smarter than the market.... they will either invest in managed funds or individual stocks....

Third, there will always be people/companies that are looking for the trade arbitrage... think day traders... if they see that a stock should be $20 and is priced at $10... they will buy it up...

 

[M Paquette]

CXO Advisory Group has been tracking the gooroos for years.

Stock Market Guru Grades - CXO Advisory

Guru Forecasts Accuracy

Jim Cramer 62 46.8%

 

[nash031]

It will NEVER happen...

First, there are a lot of people who just do not know what to do and listen to a FA.... they do not put people in index funds (much)...

Second, there are always going to be people who think they are smarter than the market.... they will either invest in managed funds or individual stocks....

Third, there will always be people/companies that are looking for the trade arbitrage... think day traders... if they see that a stock should be $20 and is priced at $10... they will buy it up...

+1

 

[Animorph]

All we need is a trader or two to set "fair" prices for stocks. Or switch back to actively managed funds. Not a big deal.

 

[Alan]

It will NEVER happen...

First, there are a lot of people who just do not know what to do and listen to a FA.... they do not put people in index funds (much)...

Second, there are always going to be people who think they are smarter than the market.... they will either invest in managed funds or individual stocks....

Third, there will always be people/companies that are looking for the trade arbitrage... think day traders... if they see that a stock should be $20 and is priced at $10... they will buy it up...

+2

The new CEO of Fidelity believes this as well

http://www.early-retirement.org/forums/f28/wsj-article-on-fidelity-76760.html#post1579496

 

[harley]

It will NEVER happen...

First, there are a lot of people who just do not know what to do and listen to a FA.... they do not put people in index funds (much)...

Second, there are always going to be people who think they are smarter than the market.... they will either invest in managed funds or individual stocks....

Third, there will always be people/companies that are looking for the trade arbitrage... think day traders... if they see that a stock should be $20 and is priced at $10... they will buy it up...

Plus, there is an incredibly powerful and wealthy industry based on convincing people to do the exact opposite of what the OP suggests. I don't think enough people could be convinced to go with indexing to overcome the impressive advertising campaigns that tell them to "trust us (FAs)". Just not going to happen.

 

[CaliforniaMan]

+2

The new CEO of Fidelity believes this as well

http://www.early-retirement.org/forums/f28/wsj-article-on-fidelity-76760.html#post1579496

People will always find a way to market their skill at beating the market. They are not timing the market or stock picking they are using "smart beta" or it will be some other clever arbitrage tool. Problem is as always, everyone is using "smart beta" or whatever tool against each other, so we are back to indexing.

We will never run out of people trying to beat the market or thinking that those that just settle for market returns as fools.

 

[Alan]

We will never run out of people trying to beat the market or thinking that those that just settle for market returns as fools.

Yes indeed, many people hate being thought of as "Mr Average" and are sure they can do better.

 

[NW-Bound]

What happens when every investor is indexing? The same thing when everybody becomes Democrat, or Republican, or Communist.

We will all retire early, drive off into the sunset in our RV, and when we die, we will all go to heaven.

Seriously, it is funny how indexers like to pick on active stock pickers, while at the same time relying on the latter to decide that a company making cancer wonder drugs, or superb lithium batteries should be worth more than the one making buggy whips. It is so that when a young company becomes successful, they will add it to their index.

 

[dallas27]

There are more variations of stock fund groupings, than there are stocks themselves. They will slice and dice until 100 versions of every conceivable idea is possible, even a fund of stocks that are not in any funds.

No effect, except fees are now annual versus transactional. Is that better?


Sent from my iPhone using Early Retirement Forum

 

[samclem]

We will never run out of people trying to beat the market or thinking that those that just settle for market returns as fools.

And I thank goodness for them every day. These people keep the market efficient, and they assure indexing continues to work. I'm a free rider on the dues they pay.

Anyway, this is a subject that has been looked at a lot, and we're in no danger of approaching a time when index investors dominate equity pricing. IIRC, index funds/ETFs account for only about 15% of the equities in the market.

 

[donheff]

If everyone invested in indexes, everyone would get the true market value (growth and dividends of the underlying companies). Isn't that the whole point in the first place?

 

[NW-Bound]

Let's reread what the OP wrote.

If say Northern Widget Co and Southern Widget inc both in the same business and with the same sales and profits, say both sell for $10/share.

Now lets further say Southern Widget inc gets into a new line of business and they double earnings per share and Northern Widget Co doesn't change, then one share of Southern should be worth $20 and Northern would still be worth $10. However, index funds don't buy and sell based on earnings, they hold the entire market. Who is left to push up Southern closer to share price of $20 ?

Without active investors, indexers buy and sell every component company in a fixed proportion (until the index committee decides to add or to throw out a company).

There is no reward, i.e. price appreciation, for a company doing well vs. a company doing poorly, if it weren't for the active stock owners who set the individual stock prices via market action.

 

[samclem]

If everyone invested in indexes, everyone would get the true market value (growth and dividends of the underlying companies).

By making buy/sell decisions using all known factors about each company and each stock, it is the active investors that establish true market value. Index investors don't help with that. We just take advantage of it.
In theory, if there are too many index investors, they would distort the pricing signals and soon many stocks would be selling for more or less than they would be objectively worth. Luckily, at that point the payoff for ective investing would be really good and more people would start doing it again.

Any system that effectively harnesses individual [-]greed [/-] ambition for the public good is a wonderful thing.

 

[pb4uski]

Yes indeed, many people hate being thought of as "Mr Average" and are sure they can do better.

I guess then that it is a fascinating paradox that index investors who are allegedly settling for average more often than not end up with above average performance. How does that happen?

 

[Alan]

I guess then that it is a fascinating paradox that index investors who are allegedly settling for average more often than not end up with above average performance. How does that happen?

Perception. That is why I said "thought of as being ". When people perceive that they are average they will try and do better. Index investors know they are beating the average.

 

[Texas Proud]

Just as an aside.... I remember when I was taking my portfolio analysis class when I was young... the prof said that it would not be hard to beat an index such as the DOW...

All you have to do is look at the companies and pick the worst one or two companies and not buy them... buy all the others... more than likely those companies will be below the avg of the rest and you will beat the index....

 

[NW-Bound]

I believe many active investors trail the market because they chase performance, and buy and sell at the wrong time. In the most recent stock bubbles, the internet stock owners in 2000 and the financial stock owners in 2009 got hurt big time. Just because the efficient market is constantly evaluating companies, it does not mean that it is always rational in its valuation.

The index investor is more diversified; he gets hurt too when the bubbles burst, but to a lesser degree.

 

[ERD50]

Just as an aside.... I remember when I was taking my portfolio analysis class when I was young... the prof said that it would not be hard to beat an index such as the DOW...

All you have to do is look at the companies and pick the worst one or two companies and not buy them... buy all the others... more than likely those companies will be below the avg of the rest and you will beat the index....

I seem to remember studies to the opposite - buy the 'worst', they are already down-trodden, and on average, recover over time to beat the market. Contrarian investing.

If I recall, it was a pretty stable advantage, but small and took a long time to benefit, so not very popular. So it still might work. And it might be a hard sell for a fund manager - we buy only the worst stocks! 'Contrarian' sounds better.

-ERD50

 

[NW-Bound]

I have likened index investors to people who do not vote. Whether you vote or not, you still end up with the same government.

So, how do non-voters win? They save themselves the aggravation. If you are gun-ho politically, and spend a lot of time to promote your candidate, you may get the elation of victory, but just as often the bitter defeat.

So, why not let other people slug it out, and you spend your time doing something else more enjoyable?

... All you have to do is look at the companies and pick the worst one or two companies and not buy them... buy all the others... more than likely those companies will be below the avg of the rest and you will beat the index....

... I seem to remember studies to the opposite - buy the 'worst', they are already down-trodden, and on average, recover over time to beat the market. Contrarian investing...

I think both methods can work. The difference is in the timing. If you can see in advance what stocks will underperform, you will do well to avoid them. On the other hand, you can also wait until it has fallen off its horse and been dragged to near death, and if it manages to survive (Sears, anyone? I would not), the rebound is going to be profitable.

Ah, but that's the theory anyway. In practice, well you know, it might be better just to be agnostic, just like our non-voter.