Index fund bubble: fact or fiction?

 

There is a common retort to those of us who are index fund investors. The retort is based on a thought experiment: “Index fund investing can’t be a good idea because if everyone did it the market would collapse!” This is known as the “tail wagging the dog” problem or, in other words, “the index fund bubble” problem.

The idea is that index funds are meant to track the market. So when active managers put money into a bunch of stocks and those stocks do well, the index fund tracks the success (or failure) of that collection of stocks. This is why the index fund strategy is considered passive: it literally just follows the success/failure of other investors. 

However, what if everyone put their money into passive index funds? In this scenario, the index funds wouldn’t necessarily be tracking the market, rather, they would be driving the market, which is not really how index funds were originally designed to operate.

What would happen? Well, for starters, we need to think about why people invest in index funds in the first place. In the most basic sense, it’s because they have a lower tolerance for risk compared to active management. Active investors take a higher risk profile in their portfolio in order to chase after the possibility of higher returns. For some people, this is fine. It’s just how their brain operates. They do not have the patience for being “average” – they want to be above average and beat the market is they can get above average returns. Of course, the index investor usually believes such a chase is folly in the long run but we can bracket that argument for another conversation.

So, going back to our hypothetical scenario, if everyone was invested in index funds, there would be by definition less competition in the active fund space. There being less competition would make it possible that a highly skilled, driven, and savvy investor would have a higher chance of beating out the index investors if they just did a lot of research and started to actively manage. And suppose this savvy investors had the stomach for a higher risk profile given they value the possibility of higher returns.

It would therefore make sense for this investor to stop index fund investing and go back to active investing, especially given there is no competition in the active management space. This could this this one investor to being wildly successful if they can predict the future of the market. If they are successful, other people passively investing who also have a stomach for risk and appetite for higher returns would see the success of that investor and also get back into active investing.

After awhile, more and more people would be back into active investing and the active management space would once again be where it is today: thriving and filled with a ton of competition among skilled and savvy traders. And us index investors would be continuing the same strategy as before given our appetite for risk hasn’t changed.

And thus, as my little thought experiment shows, there will likely always be a balance between active and passive investment because there will always be people with different psychological appetites for risk. For people like me who don’t want to stress about day-to-day volatility and simply prefer to buy and hold forever, investing in low cost, low fee index funds just works. I don’t need to chase after higher than average returns because for me the average return of the S&P 500 is plenty high to fuel my financial goals.

But some people’s goals are much loftier, and that’s exactly why there will never be a case where 100% of investors are in the stock market. There is thus no reason to worry about some kind of hypothetical “index fund bubble” or scenario where index funds would somehow break the market. It’s just never going to happen. Active management will always be a thing unless somehow there is a massive shift in the fundamental psychological makeup of the human population.

 

 

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