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Passive investing next market bubble?
Old 09-04-2019, 08:05 AM   #1
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Passive investing next market bubble?

The guy who scored on the last big bubble of market derivatives, Michael Burry of Big Short fame is advising investing in index funds and other passive investments are in a bubble condition.
https://www.cnbc.com/2019/09/04/the-...et-bubble.html

Supposedly nearly half of all investing is in etfs and index funds. Do you buy in on this premise? If so what are your fall back positions besides individual stocks and/or active funds?
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Old 09-04-2019, 08:13 AM   #2
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Beat me to it...
the original article...
https://www.bloomberg.com/news/artic...-subprime-cdos

And an article about index funds:
https://www.investopedia.com/article...ndex-funds.asp

In 2008, it was housing... though more diverse, but really, the strength of the underlying asset classes that back current funds.

How would the government bail out another crisis? .... and who would lead the charge if it happened?
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Old 09-04-2019, 08:45 AM   #3
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What seems to be implied is that these funds are not actually "buying" the shares (low volumes traded in many of the index components) but pretending to buy the shares through instruments like derivatives. If that's the case, then the fund shareholder doesn't actually own anything except the financial instruments used to emulate buying and selling shares. If this interpretation is correct (please correct me if I'm wrong), then the stock market is a very dangerous place to invest.

More likely, these funds do own shares, but also play with derivatives to smooth out buying and selling. That's less risky, but is in no way a simple buy and hold strategy.

ETA: Even more likely is the idea that only a few of the stocks in each index are "in play," and the others are not. Then the funds are not representative of the index, but just some components of the index, and everyone in the index fund business only buys and sells those stocks.

None of these interpretations makes me want to be in the stock market...
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Old 09-04-2019, 12:55 PM   #4
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My take is that his problem is three basic items:

1) Central Banks have taken interest rates so under control that risk is no longer properly identified in bonds. This makes valuation of a stock index very problematic because bonds seem to imply there is no risk in most countries for bonds.

2) Price discovery does not happen on stocks any longer since most shares are owned through passive funds and he gives the example of hundreds of billions of dollars in the Russell 2000 through passive funds, yet over 55% of the companies in that index trade more than a million dollars a day. As total investments in passive funds continues to increase this is not a problem, though the price of the company is not through trading but through indexing. Not spoken but implied is reason so little trading is that these stocks might be greatly overvalued.

3) Once you get to a selling event, say the holders of Russell 200 ETF's decide to sell 50 billion of the index in actual sales, there is no bid for these stocks, there is not enough market action to absorb the selling, and the structured investments that give cover to passive funds to hold less in stock value than the fund represents would come under tremendous pressure in a major market move, perhaps causing ETF's to lose more in value than the index itself.
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Old 09-04-2019, 01:23 PM   #5
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Even the late Bogle who invented index investing worried about the risk when indexing takes over the investment world.

I do not know about how derivatives are going to affect stock movements, but the risk that I know about is the one that is commonly voiced, including by Bogle.

When you buy an indexed ETF or MF, you buy everything in that basket, even if that basket contains some rotten apples like GE. And if you are suspicious of high-flying stocks and fear that they are overvalued, you cannot avoid them. They are all in the basket, and in fact when you buy the S&P, you buy more of the high flyers than the undervalued ones.

And then, when the market crashes, everything got dumped when people sell their index funds. Look at Berkshire Hathaway. During the crash of 2008-2009, BRK went down as much as the S&P, although the S&P had lots and lots of financial and banking stocks that deserved to be bankrupt, while Buffett was sitting on tens of billions of cash that he used to bail out a few of the aforementioned weak companies.

So, when the market crashes, all stocks will get pummeled, whether they are overvalued or undervalued. Just be ready to swoop in and buy the good ones.

PS. I remember that prior to the Great Recession, Bogle already lamented that the financial companies took up a huge percentage of the stock market valuation. If I remember right, it was almost 20%. Bogle complained that these guys were just middlemen, and while they provided a service to society, their role and value should not be worth that much.
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Old 09-04-2019, 01:44 PM   #6
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The thesis is not logical.

Suppose it was the Good Old Days and investors were buying individual stocks. Take the float on each of those stocks, multiply by its price, add them up and you have the total market cap.

Suppose it was the Brave New World and all investors were buying total market index funds. Take the NAV of all those fund holdings, add them up, and (surprise!) you get the total market cap.

The point being that people using total market indices are, in aggregate, pretty much buying the same stuff they would have bought as individual stocks.

Where people are not buying the total market, like those in S&P 500 funds, there is some limited reason to argue market distortion, but since (IIRC) the S&P is about 80% of the market it is almost the same situation anyway.

Remember, most of the growth in indexing has been at the expense of stock pickiing funds. So when those fund shares were sold, the funds sold the underlying stock, only to see it bought by the index funds. Think of a jar of M&Ms separated by color. Stir the jar and it becomes more homogeneous but it is still the same M&Ms.
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Old 09-07-2019, 06:02 PM   #7
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Originally Posted by nwsteve View Post
The guy who scored on the last big bubble of market derivatives, Michael Burry of Big Short fame is advising investing in index funds and other passive investments are in a bubble condition.
https://www.cnbc.com/2019/09/04/the-...et-bubble.html

Supposedly nearly half of all investing is in etfs and index funds. Do you buy in on this premise? If so what are your fall back positions besides individual stocks and/or active funds?
My mutual funds and ETFs are paying dividends now and I expect them to continue to do so no matter what the NAVs do. It sounds like he is a greater-fool investor.
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Old 09-07-2019, 06:41 PM   #8
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I think lots of people panic and sell everything indiscriminately in their scramble to “get out” when crashes happen - indexes or not.

And speculating individual investors as well as professional investors get hit with margin calls and have to sell whatever is still up, so good stocks get taken down with bad. We see this during any market disruption. Index funds didn’t change this.
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Old 09-10-2019, 11:17 PM   #9
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I sometimes wonder about the price discovery aspect of indexing. I do not know the percentage of the market (of a specific stock in question) that is held in passive indexes but once it gets to a certain point it would seem ripe for deep pocket investor manipulation.

For example assume a company with a 1 Billion in market cap, where some big percentage N is held in passive funds. At what value of N do things start to get interesting? If 60-70% was passively held then someone with 100-200 Million in cash could seemly bid the stock price up appreciably, as there would not be enough active sellers, causing the price to rise and in turn cause the passive indexes to start buying more to fulfill their obligations. Once enough momentum was created to raise the price appreciably the original deep pocket investor could start selling their appreciated shares to all meet the passive fund purchase demands.
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Old 09-11-2019, 06:28 AM   #10
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"The recent flood of money into index funds"

I had to stop there. Without a graph or stats to back up that statement.

I thought they had been somewhat consistent.. with both inflows and outflows already over the last few years.

Passive investing is very passive and many people have it on automatic reinvestment. Also, it just doesn't involve selling everything suddenly.

It just sounds like a scare monger article to get people into FA's... Who are going to put you in mostly the same underlying investments anyway.
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Old 09-11-2019, 09:20 AM   #11
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I sometimes wonder about the price discovery aspect of indexing. I do not know the percentage of the market (of a specific stock in question) that is held in passive indexes but once it gets to a certain point it would seem ripe for deep pocket investor manipulation.

For example assume a company with a 1 Billion in market cap, where some big percentage N is held in passive funds. At what value of N do things start to get interesting? If 60-70% was passively held then someone with 100-200 Million in cash could seemly bid the stock price up appreciably, as there would not be enough active sellers, causing the price to rise and in turn cause the passive indexes to start buying more to fulfill their obligations. Once enough momentum was created to raise the price appreciably the original deep pocket investor could start selling their appreciated shares to all meet the passive fund purchase demands.
I wonder this too, but I also consider that currently, only a fairly small % of shares are bought/sold each day, so it seems that is all that is needed to set the price. Using Apple as an example, Yahoo! states:

Avg Vol (3 month) 25.49M
Avg Vol (10 day) 23.58M
Shares Outstanding 4.52B

That's ~ 0.55% of shares traded, and the price can be quite volatile at times.

So does it matter if a high % is held by passive investors? I tend to think that you will always have some traders, seems it won't take much. And as other's have commented, I would expect it to be a self-correcting 'problem' - if active trading becomes more profitable, more will do it, until a high % of passive investing is no longer a 'problem'.

Just my thoughts, no way to know for sure, but it's enough that I'm not gonna worry about it.

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Old 09-11-2019, 10:06 AM   #12
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I will tell you a true story about price manipulation that I witnessed at a megacorp where I did contracting work.

This megacorp 401k allowed its employees to move money in/out of company stock with no restriction. And it could even be on a day-by-day basis, meaning you could buy company stock one day, then sell the next.

Now, you are not buying the actual company shares as they are traded on the exchange. Rather, you buy shares of a fund whose sole holding is the company stock, which it buys/sells on the behalf of all 401k account holders.

Here's where they screw up big time.

The fund is operated like a mutual fund. If you put in an order to buy $100,000, the price that you get is the NAV of the fund at market closing that day, and that NAV is of course computed using the company stock price at closing. Just like a mutual fund.

So, let's say that the company stock closed at $100 that day. They say your $100K is worth 1,000 shares, and let the record shows that. However, they do not have those shares yet. The next day, they go out and buy them for you. However, the shares have moved up to $101. You just got yourself a $1K gain.

Now, some people will say that, "But there's no guarantee that the price will go up. It could easily go down. It's all random".

But is it really random?

What happened was that a group of employees who each had a 7-figure account coordinated to move money in/out of this fund in unison. Together, the trading volume was high enough to move the stock price a good fraction of a percent. Yes, they were trading a few $100M each day.

So, now the stock price has gone up from $100 to $101 the next day, they all sold, and were guaranteed the price of $101. Now, the day after next when the fund went out to the exchange to sell, the selling dropped the price to $99. They are now buying again.

The effect was so clear that I wish I had kept the plot of the stock price that showed a square wave up/down with each day, and it lasted a couple of weeks or so.

This group of employees made out like bandits. Yet, they were trading according to what the company allowed.

Now, if I were an outside investor who held this stock, I might have spotted this repetitive up/down movement, and wondered what it was about, but I would not lose money if I just bought and held. The other holders of this fund however lost out, because the fund was buying high/selling low.

When I showed this to some employees at this company, they were incredulous at first. But then, one guy plotted out the price movement of the fund vs. the public stock price, he saw that the fund price kept going down and down with time. And it was significant at a few percent over a month or two, while the fund ER was minimal at a fraction of a percent per year.

A whistle was blown. The company then changed the rule to allow trading in/out of that fund once a month or so. Employees could still trade daily, but would incur a penalty of 1/2 percent or something like that. The shenanigan stopped.
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Old 09-11-2019, 10:12 AM   #13
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I sometimes wonder about the price discovery aspect of indexing. I do not know the percentage of the market (of a specific stock in question) that is held in passive indexes but once it gets to a certain point it would seem ripe for deep pocket investor manipulation.

For example assume a company with a 1 Billion in market cap, where some big percentage N is held in passive funds. At what value of N do things start to get interesting? If 60-70% was passively held then someone with 100-200 Million in cash could seemly bid the stock price up appreciably, as there would not be enough active sellers, causing the price to rise and in turn cause the passive indexes to start buying more to fulfill their obligations. Once enough momentum was created to raise the price appreciably the original deep pocket investor could start selling their appreciated shares to all meet the passive fund purchase demands.
Interesting idea. The ghost story about "price discovery" is usually argued based on the % of the market cap that is held passively and ignores that fact that passive funds do not trade like stock-pickers. So the stock-pickers will be responsible for the vast majority of actual trading even as the passive funds comprise more and more of the holdings. Hence, price discovery should be alive and well. Also, if mispricing occurs the stock-pickers will move instantly to exploit it. Who knows? Stock-picking might start to work again.

Re your idea of market manipulation I have not seen that one before. In addition to being an illegal "pump and dump" scheme it would require massive amounts of money and would be hard to hide. But regardless, we hold about 8,000 stocks worldwide through Vanguard's total world funds, so we have diversified away any effect of such manipulation even if it occurs.

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... It just sounds like a scare monger article to get people into FA's... Who are going to put you in mostly the same underlying investments anyway.
I think it is simpler and more innocent than that. The Labor Department estimates that about 950,000 people work in the investment industry. Add in the web sites, magazines, pundits, and other hangers-on and you have a very big number.

The vast majority of these people depend on the investing public believing that stock-picking still works like it did for Ben Graham in the 1930s and for his famous disciple, Warren Buffet, in the following decade or two. So the death of stock-picking is an existential threat to these folks and they are sowing FUD and obfuscation as fast as they can. IOW, I don't think it's just the FAs.

Here's a quotation I use in my investing class: "It is difficult to get a man to understand something when his salary depends upon his not understanding it” --- Upton Sinclair
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Old 09-11-2019, 10:18 AM   #14
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Again, the above story happened at a megacorp where I was consulting.

At an earlier megacorp where I was an employee and had a 401k account, here's how they did it.

They actually went out and bought shares for you, and at whatever spot price that was on the market at that point. No guarantee what price you will get. If you buy a lot, the price goes up. You sell a lot, the price goes down.

Moreover, it was before the time of the Internet. You filled out a form, and sent it in to HQ out of town. Your order would get executed some time next week. Who knew what price it would be then.

There was no day trading then. No shenanigan possible.
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Old 09-11-2019, 10:55 AM   #15
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The thesis is not logical.
Remember, most of the growth in indexing has been at the expense of stock pickiing funds. So when those fund shares were sold, the funds sold the underlying stock, only to see it bought by the index funds. Think of a jar of M&Ms separated by color. Stir the jar and it becomes more homogeneous but it is still the same M&Ms.
I think the argument is that without indexing, stocks would be purchased based on their underlying value - the stock picking mix would be very different than the ETF mix - therefore you would have a different mix of M&Ms with more green M&Ms from the valuable companies and fewer of the lesser valued brown ones that nobody wants to eat. When it comes time to distribute the M&Ms, it would be easier to share the underlying value green M&Ms than the brown and green ETF mix.

The ETF strategy sounds like a lazy Wall Street Marketers dream. Eliminate the management risk [and save the huge costs of managers and analysts] and pass [some of] the savings on to the consumer by selling them a middle-of-the-road grab bag of everything in the market or sector, instead of a curated blend of performing stocks. They can reasonably promise a market return - which is better than a lot of stock pickers' results, including their own - with no added risk. And computers can handle all the trades.

Usually when it sounds too good to be true, it is. IMO, when ETF's become predominant, they can't help but become a drag on the market because of their indiscriminate use of investment capital. I feel badly for those quality companies that are dragged down by ETF investing that distorts the real value of the market and creates more volatility for investors [now that ETFs are such a large part of trading volume]. I'm not sure ETFs would ever be the cause of a market crash, but they would certainly make the effects much worse.
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Old 09-11-2019, 12:02 PM   #16
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I think the argument is that without indexing, stocks would be purchased based on their underlying value - the stock picking mix would be very different than the ETF mix - therefore you would have a different mix of M&Ms with more green M&Ms from the valuable companies and fewer of the lesser valued brown ones that nobody wants to eat. When it comes time to distribute the M&Ms, it would be easier to share the underlying value green M&Ms than the brown and green ETF mix. ...
This would be true if there were pricing inefficiencies, but I don't know of anyone who argues that inefficiencies are widespread. With about 10,000 funds intensely studying about 3,500 US stocks it seems likely that any inefficiencies would be quickly corrected. Which leads to ... (ta-da!) ... the Efficient Market Hypothesis. I don't know of anyone that argues that the markets are not efficient in the long term, though the behavioral economists like Richard Thaler have a grand time pointing out the inefficiencies in the short term. Said more concisely, no one knows what color M&M will be the best.

Here is a video of Eugene Fama and Richard Thaler discussing the question: https://review.chicagobooth.edu/econ...kets-efficient

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The ETF strategy sounds like a lazy Wall Street Marketers dream. Eliminate the management risk [and save the huge costs of managers and analysts] and pass [some of] the savings on to the consumer by selling them a middle-of-the-road grab bag of everything in the market or sector, instead of a curated blend of performing stocks. They can reasonably promise a market return - which is better than a lot of stock pickers' results, including their own - with no added risk. And computers can handle all the trades.
Well, evidence in the industry is not consistent with this theory. As they are slitting each others throats on price they continue desperately arguing that stock picking does work and desperately spreading FUD about passive investing. Mergers and layoffs abound; I don't think anyone considers this trend to be a dream. Many, like Abigail Johnson of Fidelity, seem to have their heads buried in the sand.

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Usually when it sounds too good to be true, it is. IMO, when ETF's become predominant, they can't help but become a drag on the market because of their indiscriminate use of investment capital. I feel badly for those quality companies that are dragged down by ETF investing that distorts the real value of the market and creates more volatility for investors [now that ETFs are such a large part of trading volume]. I'm not sure ETFs would ever be the cause of a market crash, but they would certainly make the effects much worse.
Well, to be clear not all ETFs are passive. Most are sector index funds of some sort and there are quite a few stock-pickers as well. Passive (total market, etc.) mutual funds are actually not a major factor in trading volume and certainly don't increase volatility. As far as "dragging down" I think most critics of passive investing argue the opposite -- that it can result in artificially high prices, for which there is evidence in the S&P 500. That's why front-running stocks coming onto or leaving the S&P is popular.

Sector ETFs may be a major factor in volatility; I don't know. But that is really no different than stock-picking, which the market is quite used to dealing with. If I had to bet, I think I would bet on program trading being the biggest contributor to volatility. Have you read "Flash Boys?"
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Old 09-11-2019, 01:16 PM   #17
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According to CNBC, passive index investing now controls 45% of all assets for U.S. stock-based funds.

According to MarketWatch only 6% of the market is owned by ETF's. (so ETFs aren't causing a bubble)

Taken together, those statistics seem contradictory or dangerous, take your pick.

Perhaps this speaks to how ETF's actually hold their assets (or not) - as suggested by Another Reader. So, if ETFs control 45% of all stock-based assets but only own 6% of the market, it may work great for ETFs in an up market; but it sounds like a trainwreck for investors in a declining market.
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Old 09-11-2019, 01:41 PM   #18
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Yeah, many discussions of ETFs get somewhat crazy because the author thinks that ETFs are all index funds, which they are not, and all passive investments, which they definitely are not.

In Olden Times, my understanding is that ETFs started out as index funds like the grandaddy of them all SPY. Then, as the hucksters discovered that they could gull unsuspecting investors by adding the word "index" to a fund name, things started to get crazy. Now, truly passive funds like VT are in the minority and the hucksters are fleecing investors who have been told that "index investing" is the way to go. In reality, investing in sector funds is not much different than stock picking.

@starsky, maybe the discrepancy you see is due to mixing terms. ETFs might own only 6% of issues but 45% of the market cap. Even that doesn't seem tenable, though, because the S&P 500 stocks are about 14% of the stock names (500/3600) and about 80% (IIRC) of the US market cap. I dunno.

And just to thicken the stew, I have read that 60% of large cap investing is now passive. That number would include, however, institutional investors like pension funds which may not be using public mutual funds as a tool.

(Historical artifact: The index fund was invented at Wells Fargo in 1973 as an option for Caterpillar's pension fund investments. Bogle didn't start his public fund until two years later.)
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Old 09-11-2019, 02:04 PM   #19
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"Even the late Bogle who invented index investing worried about the risk when indexing takes over the investment world."

I have read and watched many bogle books and interviews including hearing him speak at the 2017 Bogleheads. I do not recall him having worries about indexing taking over the investment world.

Could you direct me to the speech, book, or interview where he worried about the risk?

For the record, I don't see indexing ever taking over enough of the market to negatively affect pricing. People will always think they are smarter and greed will always be evident.

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Old 09-11-2019, 02:21 PM   #20
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This would be true if there were pricing inefficiencies, but I don't know of anyone who argues that inefficiencies are widespread. With about 10,000 funds intensely studying about 3,500 US stocks it seems likely that any inefficiencies would be quickly corrected. Which leads to ... (ta-da!) ... the Efficient Market Hypothesis. I don't know of anyone that argues that the markets are not efficient in the long term, though the behavioral economists like Richard Thaler have a grand time pointing out the inefficiencies in the short term. Said more concisely, no one knows what color M&M will be the best.
Great reply (all of it). Thanks!

From another perspective, stock ownership favors Corporations who have a potentially infinite lifespan. We don't get that luxury, so our 40-50 year earning cycle may or may not be in sync with the market.

Regarding inefficiencies, with stocks trading at multiples of 25 and higher, it's hard to argue that the market is truly financially efficient for individual investors. Like many systems that depend on consumer confidence, the market is perfectly efficient until it isn't. Over an infinite timeline, as distortions work themselves through the market, the aggregate efficiency of the market may be perfect; but the singular impact on us humans who participate in the market in our own time, is by definition imperfect. (I think I'd like Thaler. )

This is one part of the truthy salesmanship to promote stock ownership to individuals as long-term retirement investments - that the long-term market returns are just like your returns if you just hang in there. A whole lot depends on when you start and when you finish. (plus picking the right stocks, and buying at the right prices, fees, etc...) We rarely have the luxury of choosing when we have the money to invest.

Imagine targeting your retirement for 2009. I remember my ready-to-retire co-worker's shell-shocked face in '09 when both her stocks and home equity went down the toilet.
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