What happens when everyone is using index funds?

[gcgang]

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


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[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]

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]

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]

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]

... 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]

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]

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]

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]

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]

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]

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.

 

[RetireBy90]

True, but "the total market" would do worse and worse. Without the discipline of active investors looking for 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.

Thanks Samclem, that was my original thinking. As more and more move to index funds the market would become less efficient. Once large numbers catch on to index investing, it would become less productive. At least my thought, I read that on the Internet somewhere, must be true

 

[NW-Bound]

So, if the active stock pickers keep picking the wrong stocks (because they are not even as good as chickens), while the indexers just go along with the flow, why don't buggy whip companies keep getting higher and higher prices over time, while good companies get cheaper and cheaper?

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...

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

Drawing the parallel to the political arena, I may just stop voting one of these days. I never bother to actively participate in any political movement, because I rely on different factions to keep each other in balance.

 

[samclem]

So, if the active stock pickers keep picking the wrong stocks (because they are not even as good as chickens), while the indexers just go along with the flow, why don't buggy whip companies keep getting higher and higher prices over time, while good companies get cheaper and cheaper?

The chicken experiment Alan described best models "technical rolleyes analysis" (foretelling future based on previous patterns of stock prices), not "fundamental analysis" (based on an assessment of the relative value of securities). To simulate fundamental analysis, the chicken and the human subject would need to be given access to the algorithm that turns each light on.

I believe a sufficiently talented analyst (or team) given sufficiently good information can (and do) spot underpriced and overpriced equities at a greater-than-random rate. But I don't think I can do it, and I don't think I can identify a priori those who can. And, the cost of trying to play the game exceeds the expected value of the results. So, I'll take the better-than-average average via indexing.

Drawing the parallel to the political arena, I may just stop voting one of these days.

If more people do that, we might get better results. But it depends who stops voting--and, like many other areas, most people think their acumen is "above average".

 

[NW-Bound]

... the cost of trying to play the game exceeds the expected value of the results...

I tend to agree with that.

... If more people do that, we might get better results. But it depends who stops voting--and, like many other areas, most people think their acumen is "above average".

Yes, if only I could get people who disagree with me to stop going to the poll. Indeed, darn voters keep thinking they are "above average". You can't win.

 

[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)

I was being a bit facetious in my query. While fees are a part of it, poor stock picking by managers and active managed investors tendency to chase past performance also play a part IMO.

 

[meierlde]

I was being a bit facetious in my query. While fees are a part of it, poor stock picking by managers and active managed investors tendency to chase past performance also play a part IMO.

Boogle I believe starts with the thesis that over the long term any investment managers performance tends to revert to the mean, partly as happend with the old Fidelity fund, they get so many investors that they are essentially forced to index as they are to big to not affect the market with their investments. So if over the long term the best one can expect is to keep even with the market, then the fees make all the difference.

 

[ERD50]

I guess we will just have to wait for the next update in the Buffet bet of the index versus the hedge-fund. So far, it isn't looking good for all the sophisticated people at those hedge funds who try to determine the best places to put their money ('your money'? do they put 'their money' in the funds they sell?).

Looks like this bet might be one of their less than optimal choices?

-ERD50

 

[Alan]

Boogle I believe starts with the thesis that over the long term any investment managers performance tends to revert to the mean, partly as happend with the old Fidelity fund, they get so many investors that they are essentially forced to index as they are to big to not affect the market with their investments. So if over the long term the best one can expect is to keep even with the market, then the fees make all the difference.

Interesting misspelling, and given how respected he is I wouldn't be surprised to see a new verb come into the finance world.

"I don't know which type of asset allocation is better, let me just Boogle that for you".

 

[ERD50]

Interesting misspelling, and given how respected he is I wouldn't be surprised to see a new verb come into the finance world.

"I don't know which type of asset allocation is better, let me just Boogle that for you".

And someone could write a theme song, "The Bogle Boogie".

-ERD50

 

[Lsbcal]

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.

That is an interesting experiment and incorporates some of what goes on in the markets. But it misses some things I can think of like (1) momentum effects, (2) the value premium, and (3) the small growth negative premium due to the asset class's lottery like character.