What happens when everyone is using index funds?

[Alan]

Quote:

Originally Posted by pb4uski 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]

Quote:

Originally Posted by 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....

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?

Quote:

Originally Posted by Texas Proud ... 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....

Quote:

Originally Posted by ERD50 ... 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.

[gcgang]

If everyone indexed, it would be like what Yogi said: nobody goes there anymore, it's too crowded.


Sent from my iPhone using Early Retirement Forum

[ArkTinkerer]

If the company is way undervalued as the OP suggests there is a great incentive to buy 100% of the shares and take the company private.

[Texas Proud]

Quote:

Originally Posted by ERD50 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

But I did not say to the worst performing or the most downtrodden.... but the one that you think will perform the worst over the time period you are looking at... heck, it could have been the best performing stock the prior year....

I would agree with what you say about downtrodden stocks.... the Dogs of the Dow take....

I see NW-Bound has mentioned that it is two different investment styles....

[ERD50]

Quote:

Originally Posted by Texas Proud But I did not say to the worst performing or the most downtrodden.... but the one that you think will perform the worst over the time period you are looking at... heck, it could have been the best performing stock the prior year.... I would agree with what you say about downtrodden stocks.... the Dogs of the Dow take.... I see NW-Bound has mentioned that it is two different investment styles....

But your prof is saying that it would be 'easy' to predict the future. Why don't we have a bunch of active mutual funds consistently outperforming the index then, simply by dropping 'bad' stocks?

If this is something that is consistent and repeatable, then there must be some formula for picking the best or worst stocks to buy or drop. And if it is formulaic, other investors will discover the formula and trade those stocks, driving them to levels such that this won't work.

Did this prof manage a fund on the side and become wealthy from it?

-ERD50

[Bestwifeever]

I am sure there are active traders who are very good at it, probably even on this board (gasp!) who stay under the radar. I imagine being successful at it takes a lot more time than buying and holding index funds, both in understanding how different types of investments work and in researching the offerings and timing. We will never hear much about them but I am sure they are out there.

Remember Psst Wellesley is not an index fund yet many of us have a sizable percentage in it. Warren Buffet is not an indexer.

I don't see everyone using index funds any time soon.

[steelyman]

Quote:

Originally Posted by Bestwifeever I imagine being successful at it takes a lot more time than buying and holding index funds, both in understanding how different types of investments work and in researching the offerings and timing.

I can attest to the fact that I am very successful in spending a lot of time losing money while attempting "active" trading.

[NW-Bound]

Quote:

Originally Posted by ERD50 ... If this is something that is consistent and repeatable, then there must be some formula for picking the best or worst stocks to buy or drop. And if it is formulaic, other investors will discover the formula and trade those stocks, driving them to levels such that this won't work...

Successful traders or hedge funds managers seem to fly by the seat of their pants, and evaluate every opportunity by itself. Soros is one. He built up his multi-billion fortune from nothing, and he is a trader, not an investor or business manager like Buffett.

Man, I wish I know their secret, or have their 6th sense. I remember in an interview, a reporter asked Soros why he was still doing it as he had more than he could spend. He said that it was a test to see if he could still tell how the market was evolving.

[2B]

I was a highly successful investor in individual stocks until I actually researched my record. In the mid-90s, I started to here about indexing and scoffed at it. I knew I was a safely above average investor. Just to prove it to myself, I took my actually portfolio changes and compared it to a 75% S&P/25% Total Bond Index. When I plotted my results, I occasionally outperformed on a couple of years but didn't beat the stock heavy index portfolio over the 10 year time period. I wish I could post the graph but it's been lost to one or more computer failures and/or file deletions.

As I learned more about indexing, I never went back and redid it with more asset classes. In 2007 I was running 90% equities and decided I had "won" so I didn't need to be so heavy in equities. Unfortunately, I only went to 60% equities but it did save me some of the 2008/2009 pain.

There will be individual investors as long as egos are not validated against the real data. Of course, half of the active trader will be both above and below the index average minus their respective fees. On average on the FAs and brokers win.

[meierlde]

Quote:

Originally Posted by pb4uski 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?

Simple the fees (either in money or the investors time) are higher for active managment than indexing. Based upon the best fees are at least 10x for actively managed funds than the lowest cost index funds. Now if you are doing the management yourself, how much is your time worth? (I.E. unless you enjoy it you could be doing something else instead)

[robertf57]

I think the premise of the OP question is entirely wrong. The question implies that we as investors are competing against each other in a zero sum game which we are not. If (and of course it will never happen) every investor was using index funds, the losers would be the financial organizations who would not be receiving high fees. If everyone chose the total market index, we would all receive the returns of the total market.

[Lsbcal]

Quote:

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

I will admit that I would not want to be thought of as Mr. Average. Who would? I guess it somewhat depends on what Mr. Average is like -- is he a dull guy who is satisfied with a C grade? I don't think index investors would think of themselves that way. More then likely they would say they were willing to just settle for a B+.

I am going out on a limb and postulating that many "index investors" think of themselves as above average because they are relying on backtest results that say they are likely to beat the stupid money that trades a lot. I'm not saying they are wrong, just that many index investors do not think of themselves as "just average".

Regarding the OP, there is the whole question of "what index"? There are so many indexes out there. Some people trade indexes. And ETF's are just baskets of stocks, why not flip them? That's what many do. Have you guys heard that biotech is hot? Buy a biotech ETF to protect yourself from individual stock risk.

You can probably tell I'm having fun with this. Please don't take me too seriously (but I'm above average).

[Texas Proud]

Quote:

Originally Posted by ERD50 But your prof is saying that it would be 'easy' to predict the future. Why don't we have a bunch of active mutual funds consistently outperforming the index then, simply by dropping 'bad' stocks? If this is something that is consistent and repeatable, then there must be some formula for picking the best or worst stocks to buy or drop. And if it is formulaic, other investors will discover the formula and trade those stocks, driving them to levels such that this won't work. Did this prof manage a fund on the side and become wealthy from it? -ERD50

Nope on all questions...

The problem I see with this investment style is that nobody wants to invest in it.... lets call it the Dow 30 minus one or two.... and when you expand it to a larger index then it really does not make much sense... the S&P 500 minus one or two....

I also do not think that the amount that it would beat the index would be by that much... it would be interesting to see what the real result would be with perfect hindsight....

And how can you charge that high fee 100% managed funds can say they are much better at picking stocks.... and will charge you a good fee to do it...

It is something that would probably work... IOW, if you take the DOW, if you rank what you think the returns will be, all you have to do is pick one of the worst 15 and you 'win'.... does it make sense to do it in real life... nope....

[Texas Proud]

Quote:

Originally Posted by Lsbcal I will admit that I would not want to be thought of as Mr. Average. Who would? I guess it somewhat depends on what Mr. Average is like -- is he a dull guy who is satisfied with a C grade? I don't think index investors would think of themselves that way. More then likely they would say they were willing to just settle for a B+. I am going out on a limb and postulating that many "index investors" think of themselves as above average because they are relying on backtest results that say they are likely to beat the stupid money that trades a lot. I'm not saying they are wrong, just that many index investors do not think of themselves as "just average". Regarding the OP, there is the whole question of "what index"? There are so many indexes out there. Some people trade indexes. And ETF's are just baskets of stocks, why not flip them? That's what many do. Have you guys heard that biotech is hot? Buy a biotech ETF to protect yourself from individual stock risk. You can probably tell I'm having fun with this. Please don't take me too seriously (but I'm above average).

Your point is well taken... the results of index investing is not 'average'.... it is 'above average'.... IOW, people who invest in managed funds do worse... some a lot worse... so if you take 100 people and the index investor beats 90 people who invest in managed funds, that is not 'average'....

[samclem]

Quote:

Originally Posted by robertf57 If everyone chose the total market index, we would all receive the returns of the total market.

True, but "the total market" would do worse and worse. Without the discipline of active investors looking for undervalued stocks to buy and selling stocks they believe to be overvalued, the prices of equities would get increasingly disconnected from reality. Good young companies with smart ideas would be starved for investment capital and grow very slowly, and inefficient lumbering dinosaurs would continue to have their overly-high stock prices supported by the "auto-buy" indexers. The winners would be private capital and private companies--they'd produce better and better returns compared to the increasingly value-blind, fat public equity market. The companies in the public equity market would have falling dividends while private companies and those funded outside the public equity sphere would produce increasingly attractive returns for their owners.

Be thankful for active investors--but don't feel obligated to join them.

[Alan]

Quote:

Originally Posted by Texas Proud Your point is well taken... the results of index investing is not 'average'.... it is 'above average'.... IOW, people who invest in managed funds do worse... some a lot worse... so if you take 100 people and the index investor beats 90 people who invest in managed funds, that is not 'average'....

Many years ago I read an article about the typical sort of lab rat testing that is done, but this article was titled, "Are chickens better at stock picking than humans?". The test gets right to the heart of why many people do poorly trying to beat the market when they can do better by "being the market" and choosing index funds.

The people undergoing this experiment had no idea they were being tested against chickens and the test went like this:

There are 2 stations that give out rewards (food for the chickens, coins for the humans). Above each station is a light and if the subject is under the light when it comes on then the station delivers the reward. The lights come on randomly but are biased to one particular station. Both chicken and human subjects quickly determine which light comes on most often. Once a chicken realizes which station gives more rewards it stays there for the remaining length of the test. Invariably the human subjects try to beat the odds, see sequences that aren't there and move from station to station to try and get more than by simply staying at the station that gives out more.

Overall, the chickens easily won the contest even though some humans did do better.