What If The Entire Market Was Indexed?

What I mean by this is that the appeal of indexation strategies is great when there is enough active stock picking going on to make a market efficient to the point that you cannot reliably identify stock-picking skill in advance (or do it yourself). The more market participants participating in an auction system, the less chance there is of finding gross pricing errors (or of being able to determine skill in advance).

I don’t think it’s a stretch to view the stock market as an equilibrium system. As new equilibrium points are reached with respect to how much of the dollar weighted investment portfolios are indexed versus actively managed the appeal of indexation changes. I mention this because many people have questioned what would happen if many more people were indexing. What if the entire market was indexed? Who would be setting prices? It wouldn’t actually work, but I don’t think that’s something that we will ever encounter either.

But let’s assume that the majority of the market was indexed. The same math always applies: the passive investor net of fees will beat the average active investor, however it could be easier to identify the skilled manager in advance. Of all the actively-managed portfolios, some will beat the index and some will lose out to the index – this is how it is now too. The difference is that the application of analysis and research would more likely be fruitful endeavours.

Take this quote from the father of security analysis, Benjamin Graham, from 1976:

“I am no longer an advocate of elaborate techniques of security analysis in order to find superior value opportunities. This was a rewarding activity, say, 40 years ago, when our textbook Graham and Dodd was first published; but the situation has changed a great deal since then. In the old days any well-trained security analyst could do a good professional job of selecting undervalued issues through detailed studies; but in the light of the enormous amount of research now being carried on, I doubt whether in most cases such extensive efforts will generate sufficiently superior selections to justify their cost.”

So as more and more people index the market, a new equilibrium will be reached. Eventually active stock picking can be a reliably worthwhile activity again – but as it stands today, it is not for large and efficient markets.

Moral of the story: low-cost index funds are a prudent alternative to actively managed (long-only) portfolios in today’s day and age. That may change as indexing becomes more popular (and markets less efficient), but given human nature that may not happen.

Preet Banerjee
Preet Banerjee
...is an independent consultant to the financial services industry and a personal finance commentator. You can learn more about Preet at his personal website and you can click here to follow him on Twitter.
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Showing 8 comments
  • Traciatim

    So essentially your applying “Be greedy when others are fearful and fearful when others are greedy” to “Be active when others are passive, and passive when others are active”? Essentially it all boils down to “Figure out what most people are doing . . . don’t do that.”

  • Canadian Capitalist

    I don’t think we’ll ever have a situation where everyone is 100% passive either. Just as we’d never have a situation where everyone saves 10% of their income, exercises 30 mins. every day, eats their vegetables, don’t smoke, drink moderately or not at all, don’t do drugs etc.

  • Preet

    @ Traciatim – yeah, pretty much. :)

    @ CC – I’d be surprised if we saw 50% passive in our lifetime.

  • Silicon Prairie

    It will be a sad day when “only” getting the market average no longer beats the average investor :) Since indexes pick up the average opinion of all active investors, it’s right to say that if there were no active investors there couldn’t be an index the way we know them now. Even now when the average opinion can be severely mis-informed.

    Regardless of the balance of active and passive investing, picking individual stocks to invest in would always be likely to take a lot of time. An easier way to do it might be to judge the future returns of the index based on what you know about it now (ie, when the P/E is 50 it will never slow down!) and use that to adjust your allocation. I currently find that preferable to indexing the global markets by trying to buy indexes in proportion to their total dollar weight.

    Regardless of the current balance a good way to view things is that picking a good manager is similar to picking good stocks – it’s something you can (possibly) do it if you don’t have time but you know how. If you don’t know how to pick a good manager, take them all :)

  • Brian

    I don’t think its that far off as you guys make it out to be. 30 years ago, it would have been difficult to find a pension fund that indexed their investments. Now, I would say nearly 90% of pension funds are linked to some sort of index. When the public becomes more educated, we’ll gradually see an increase in its popularity.

  • ioana

    Hmm I don’t think that’s all that would happen.

    I’m a newbie to the financial world by all accounts. I only dare to say what I think because of the pants falling off the economists and financial advisors all over the world. If they, who are educated in the field, can be so off, then why can’t I (be off), right?

    But I think that would mean that the only stocks getting bought are the ones in the indexes.. giving the index managers undue power over … inviting corruption in this groups etc etc.

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