
The Impact of Index Investing: A Follow-Up - tosseraccount
http://www.philosophicaleconomics.com/2016/05/followup/
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JamilD
I was at the Berkshire meeting this past weekend, and Buffett gave a nice (if
simplified) explanation of investing in index funds over active investment, as
it pertains to hedge funds, hiring analysts, etc.

An excerpt from the transcript [0] follows:

What I’d like you to do is for a moment, imagine that in this room, you people
own all of America. All the stocks in America are owned by this group. You are
the Berkshire 18,000 (or whatever it is) that have somehow managed to
accumulate all the wealth in the country. Let’s assume we just divide it down
the middle. On one side, we put half the people…half of all the investment
capital in the world, and that capital is what a certain presidential
candidate might call ‘low energy’. In fact, they have no energy at all. They
buy half of everything that exists in the investment world – 50 percent –
everyone on this side. Now half of it is owned by these ‘low energy’ people.
They don’t look at stock prices. They don’t turn on business channels. They
don’t read the Wall Street Journal. They don’t do anything. They are a
slovenly group that just sits for year after year, owning half of America’s
business. What’s the result going to be? The result is going to be exactly
average as all American business does because they own half of all of it. They
have no expenses – nothing.

What’s going to happen with the other half? The other half are what we call
the ‘hyperactives’. The hyperactives’ gross result is also going to be half,
right? The whole has to be the sum of the parts. This group, by definition,
can’t change from its half of the ultimate investment results. This half is
going to have the same gross results. They’re going to have the same results
as the ‘no energy’ people but they’re also going to have terrific expenses
because they’re all going to be moving around, hiring hedge funds, hiring
consultants, and paying lots of commissions, et cetera. As a group, that half
has to do worse than this half does. The people who don’t do anything have to
do better than the people that are trying to do better. It’s simple.

[0] [https://www.biznews.com/global-
investing/2016/05/02/berkshir...](https://www.biznews.com/global-
investing/2016/05/02/berkshire-agm-transcribed-buffett-rips-into-active-fund-
managers/)

~~~
IanCal
This can cause an interesting dilemma if you assume that what people invest in
makes a difference to the output.

It may make more sense selfishly to be in the low-energy group, but the
overall returns might be lower the more people go that route.

A flawed car analogy: A driver and passenger will both travel the same
distance, but the driver spends a lot more effort per mile.

So it might both be better for each individual to be low-energy yet better for
everyone if people were more active.

It's an interestingly complex problem.

~~~
marcosdumay
Interestingly, the more bad (under average) investors move to passive
investment, the better the average outcome will get. And the more good (above
average) investors move there, the worse it'll become.

All counted, isn't it great when incentives align almost perfectly with the
global optimum?

~~~
IanCal
Ah but then we come to something I'm going to coin as "Zeno's Investors".

Passive investors achieve the average return. Active investors receive some
distribution of return but obviously it must range from some above to some
below average. 1/x investors get a worse than average return, despite their
efforts. For simplicity, let's say that 1/2 of the investors 'win' and half
'lose'.

That losing half would do better if they moved to passive investments,
allowing the top half to make the real gains. Now, we're back in the same
situation. Does this not continue on until it's selfishly best for everyone to
be a passive investor, even though overall that might be worse?

Ways I think I might be wrong:

\- The maths doesn't really work quite that way once the balance shifts away
from 50% each side. It may be possible that some proportion of active
investors will always make more profit than the passive investors. I don't
think this is right but if it is then it'd entirely break the reasoning.

\- Changes that happen from one step to the next. The winners now own more
capital and therefore we don't see the same converging series. I don't think
that matters other than prolonging the outcome, but I'd not be surprised if
I'm wrong on this count, I've not thought it through fully.

(I'm trying to be more cautious about making overly bold claims and so am
trying to point to things I know might invalidate what I'm saying, if it seems
annoying then let me know)

~~~
marcosdumay
The rational optimum with no transaction costs[1] would be finding the best
investor, and letting him make all the decisions. Everybody else should invest
on the index.

Put transaction costs there, and you get an adversarial system. Now the top
investors will try to convince the others of their own incompetence. Didn't do
the math, but the outcome is probably bad.

Now, fill the market with real humans and irrationality will make sure enough
incompetent investors will be active to let a big enough amount of competent
ones make a win. Stable again.

I'm really unconcerned about index funds.

[1] A spherical cow in vacuum.

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shostack
Here's what I haven't found a good answer to yet...

What is the risk when a large percentage of the middle class and others are
all in low fee index funds?

This seems on the surface to be ripe for exploitation in some way, or like
we'd be all exposed to the same black swan event and thus potentially trigger
another major market event simply because everyone is in the same funds.

I am not a super educated investor so if this is impossible due to the nature
of indexes please correct me, but I can't help but feel that this push towards
the Bogleheads approach may have the unintended side effect of proverbially
putting "all of our investors in one basket."

What are the risks if main street investors truly do shift to this style of
investing en masse? It seems that the investments of our middle class and
upper middle class would all take big hits at the same time which could
cripple the nation moreso than if people were in other investments.

Again, I'm probably missing something here so would appreciate being educated
on why my fears are invalid. I haven't been able to find any info on this from
googling.

~~~
JamilD
Index funds expose you to essentially the entire market; it's the sum of
thousands of tiny pieces of businesses all across America. We're not putting
all our eggs in one basket, rather, we're all distributing them across many.

If you can pick an investment that will weather an economic downturn, and
still provide a decent return — let me know, because I want to get in on it ;)

~~~
fdsaaf
But when everyone invests in everything equally, we all end up investing in
nothing!

~~~
JamilD
The previous post on the same blog debunks this.
[http://www.philosophicaleconomics.com/2016/05/passive/](http://www.philosophicaleconomics.com/2016/05/passive/)

~~~
fdsaaf
[http://www.ironbridgellc.net/PDF/hidden_risks_of_passive_inv...](http://www.ironbridgellc.net/PDF/hidden_risks_of_passive_investing.pdf)
is an interesting countervailing read

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matt_wulfeck
I love passive investing (vanguard admiral shares anyone??) but there are
several things that I find lacking:

1\. It's really boring. There's no earnings to follow, no products to watch,
etc

2\. You can't get rich from most indexes. The risk and reward is too low. It's
unlikely to invest in a index that gives you a 10x return, though it does
happen.

In the end I keep the bulk in a low fee composite index but I like to
speculate with a little, even if I invariably lose money on the spec part.
It's more fun.

~~~
bonniemuffin
If you want "fun investing", go to Vegas. I personally don't think of
investing as a source of entertainment.

~~~
savanaly
Investing in specific companies rather than indexes (which I assume is what
everyone means by "fun investing"?) isn't very much like gambling in Vegas.
With gambling in vegas you have a negative expected return with a high
variance. With stock picking you have a positive expected return with a high
variance (where do index funds fit in? positive expected return with low-ish
variance).

Although picking stocks is still not rational if your only concern is your
long run wealth, it's not irrational for the same reason as gambling. It's bad
because you have the same expected return as low cost index funds, and you
exert effort or pay fees for the privilege. That doesn't mean I look down on
everyone who actively invests though-- they may have good reason to think they
are special and can pick stocks better than average or they may just enjoy it,
as the person to whom you responded said he did. And then it would be rational
to actively invest at least some of the time.

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vibrato
I disagree that you have +EV with stock picking in general. Most companies go
out of business, most stocks go to $0.

Index funds, however, do have +EV.

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evanpw
If you want to be sure of positive expected value, just pick randomly, with
probability proportional to market cap. That gives the same expected value as
an index fund, with much higher variance.

~~~
vibrato
if you rebalance / repick, yes. If it's just buy and hold, I don't agree. The
benefit of index funds is the failing companies are dropped before they hit
$0.

~~~
evanpw
That seems like a strange perspective to me. All of the theoretical
justification for passive investing (you get the average return without the
fees, maximum diversification, etc.) implies that you'll get the best result
from holding every possible security in some proportion. You're saying that
index funds work not because of any of that, but because they've observed a
market inefficiency (low market-cap or recently-fallen stocks underperform the
market), and make an active decision to deviate from the market portfolio in
order to exploit it. Why believe that there's exactly one easily-exploitable
market inefficiency, but no others?

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jerryhuang100
_“Yes, you need to diversify... mix your more established growth names–e.g.,
your Microsofts, your Intels, your Ciscos, your Yahoos, basically, the
reliable blue chip stuff–with higher-risk bets–something like an
Astroturf.com, or an Iomega, or a JDS Uniphase, that will offer high-powered
upside if things work out for those companies. That will give your portfolio
balance, without sacrificing growth. "_

It's really a joke for this portfolio from some TV gurus from that time around
'99, as every "blue chip" companies on the list mostly worth significant lower
in '16 from their '99-00 heights: >-50%+ INTC, CSCO, YHOO (not to mentions
it's on the selling block). Maybe MSFT is an exception. Those high-risk bets?
more like busts: astroturf (?, never heard of it), IOM (from $100 to $3.56
when acq'd by EMC), JDSU (from ~$300 to $6 as VIAV and $25 as LITE). I really
do not see what growth in such portfolio.

This just reminds me the moment that Jim Cramer and other pundits on TV urging
investors to buy and hold Lehman Brothers stocks before its fall in '08
"because it's too big to fail".

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aakilfernandes
The main problem I have with index funds is the otherwise financially savyy
people who tell me that index funds will get you on average x% a year. No!
Index funds, in the past, gave x% a year. However past performance is not a
predictor of future performance.

There is no law of physics/economics that says the S&P500 has to rise at x% a
year on average.

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mac01021
Past performance should be a predictor of future performance if the forces
driving the market remain similar to the forces driving it in the past.

If they are not the same, then past performance may be a very bad predictor.
But even in that case it is hard to imagine I'd do better by picking
individual stocks unless I start researching companies as a full-time job.

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nxzero
Impact is nothing.

Whole point of indexed funds is match the market. If you feel that as an
investor you're able to beat the market, which includes indexed funds, good
luck.

"Fool and their money are soon parted."

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pbreit
The distinction between passive and active management is kind of a misnomer
anyway, right?

There's no reason an "active" manager can't just select x00 companies by some
criteria, publish that list and then just invest in that basket with modest
adjustments?

At this point, the primary advantage that "passive" management has is
extraordinary marketing, mainly through the selection of S&P 500 components.

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miseg
Dealing with retirement investment policicies offered in Ireland, I see two
sides:

1\. Actively managed funds diversified across equitieis, bonds, cash, etc

2\. Index funds for specific indices, such as "top 4,000 US companies"

The danger with 2, they say, is you're not diversified. That'll be up to me I
suppose to try to diversity into other areas.

~~~
arielweisberg
Most popular index funds are very diversified. 4000 companies not diversified
enough for you? There is research that suggests any 50 companies picked at
random will give you quite a bit of diversification.

The real lack of diversity is that it's weighted towards US companies which
some people have decided they want and others don't, and apparently it's
weighted towards stocks as an asset class as well.

I don't think weighting is the same as lacking diversification, although
certainly you are lacking one kind of diversification.

~~~
iofj
I would think that generally one means different things. Specifically, a
diversified portfolio would hold stocks and bonds.

Or, if one is of the "stocks don't go up over the long term" persuasion, it
means stocks + shorts (for a net market neutral portfolio) and bonds.

So no, popular index funds are not diversified. There are exceptions, of
course.

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known
Gold gave better returns in last 10 years [http://www.nsegold.com/why-invest-
in-gold.php](http://www.nsegold.com/why-invest-in-gold.php)

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atemerev
Passive investing is popular when markets are good. And there wasn't any
significant crisis since 2008-2009.

When markets make a downturn, passive investing is not a great idea.

~~~
ryangittins
When the market takes a dive is the _best_ time to invest in index funds. The
problem comes when people panic and pull out their money in a recession,
realizing the loss. If the market rebounds you come out ahead and if it
doesn't, you've got much bigger problems.

The best policy is to put money in the market every month, through the best
and worst of it, especially if you're young.

~~~
paganel
> The problem comes when people panic and pull out their money in a recession,

This doesn't happen only because of panic.

In a recession, by definition, bad things happen: people lose cushy jobs, they
end up uninsured just before an illness happens, very close relatives
(parents, kids) fall on hard times them-selves and you have to bail them out
etc etc. All these new problems require liquidity, which can be very easily
obtained by selling your stocks, even if at a loss. Multiply this across the
whole middle-class and the end-result won't be pretty.

~~~
ryangittins
Fair point; this stuff certainly doesn't happen in a vacuum.

I should have mentioned that investing comes with the caveat that one should
also have a plan for major life events like a job loss. Having 6+ months of
living expenses on hand _in cash_ is a must. I firmly believe that 70%+ of the
stress and anxiety of losing one's job is the pressing need for cash flow. I
can't imagine the kind of stress that produces for someone who lives paycheck
to paycheck.

That brings me to a larger (slightly off-topic) point: people don't save
enough money. 10% is the absolutely _minimum_ one should be saving, despite
that being the common advice which no one follows. Most people, _even high-
earners_ , spend nearly _all_ of their money. There are _tons_ of people out
there making $75k+ per year who are a couple paychecks from being on the
street. Those people are simply doing it wrong and will absolutely get bit in
a down market.

For those still reading, do this: Get an emergency fund that you can live on
for 6+ months. Pay off your debts. Contribute to your IRA, 401k, or whatever
else, putting all of that money into a boring index fund that tracks the
market (I like VTSAX because Vanguard's fees are incredibly low). Make sure at
least 20% of your money is invested. The only people who this _might_ not work
for are those earning at or near minimum wage with dependents. If you're not
in that group, just do it. You do not need that 20% of your money right now.
You may think you do, but you don't. You're spending money on stuff you don't
need.

My apologies for getting so far off topic. This is just something I feel very
passionately about.

~~~
ececconi
I don't see the difference between having cash on hand and having stocks. You
can sell on the market five days a week. Add multiple credit cards with a very
high credit line on them you effectively have about 30 days to sell stock from
the emergency point.

Why keep stocks over cash? Even if they don't appreciate, or even if it is a
down year, they still pay dividends which can be reinvested.

~~~
ryangittins
Consider this scenario (which is not out of the realm of possibility):

You stick $10k in the market when shares are $10 each. This means you get 1000
shares. Then the market crashes and now those 1000 shares are worth $5k.
Normally this would be fine; you know the market will rebound eventually.
_Then_ you lose your job and have no cash on hand.

You're out of the job for a few months, and you slowly sell your shares until
you find a new job. Say it takes $4k to keep you afloat for a few months. You
now have $1k left in the market, 200 shares. That $4k of spending actually
cost you $8k. Though the market rebounds eventually and your remaining 200
shares are worth the $2k they originally were, you're still $8k short and you
always will be. That money is gone. It would've taken more than 20 years for
inflation to turn $8k in cash into $4k.

In short, cash is a cheap hedge against some bad luck eating up your
investments. The inflation that slowly devalues your cash is a _much_ more
acceptable risk than the one I describe. Markets can be rough in the short
term. It's easy to hedge against them. Do it.

~~~
ececconi
To that I say you can have an even cheaper way to hedge against risk by having
put options on the stock you own.

Also your example assumes that all the shares were bought at the same time and
declined 50%. If you've been investing for years, the value of your
gains/losses wouldn't simply be a "market crash" it would include the price at
which you bought the stock at plus any dividends you reinvested. So a 50%
downturn from a certain high point could be much less from how much capital
you initially committed. Add to that you can take capital losses as a way to
reduce tax liability in a given year.

There's enough ways to hedge without having too high of a cash drag.

~~~
ryangittins
The cost of inflation (at, say, 3%) is $30 for every $1k you have in your
emergency account. That's $150 per year if your emergency fund is $5k, or $300
if it's $10k.

I'd be surprised if the combination of the effort it takes and the fees that
are charged are less than that for your method.

That being said, it's sounds like you have a firm grasp on your system and it
works for you. That's much more than can be said for a vast majority of
people.

~~~
ececconi
Cash is a great thing, it's something you don't have to worry about and
usually is FDIC insured. Personally, I'm holding onto quite a bit right now
because I think much of the market might be overvalued. I think I was just
trying to see if I could think out a case where you could in theory not worry
about not having too much of it on hand.

