I ran across a hypothetical question – what happens when Vanguard owns everything? – which was followed up with a rebuttle and reply. For something that will never happen it was a decent read with a nugget of information buried at the bottom:
Financial Analysts Journal paper by Rodney Sullivan and Morningstar’s own James Xiong that raises a warning flag about spillover effects with market-cap indexing. In the words of the authors, the growth in market-cap indexing has led to “increased volatility” and “marketplace fragility.”
That brings up another question – whether indexing can get too big?
You can’t knock the importance of index funds to the average investor. We’ve never had an easier time accessing extremely low cost investments in so many different markets.
That access comes at a price. With more people putting more money into index funds, it adds more market wide concerns – volatility and liquidity – when it matters most.
Volatility is a sore spot for many investors. Actually, they hate the perception volatility creates. When a fund or the market falls quickly, all investors see is bigger losses in the future. “Get out quick and save what you can” is the first thought and many do just that.
If enough investors react the same way, it affects prices in a bad way. The selling causes more selling because other investors see similar further losses in their funds. And it spreads.
The increased use of index funds is the epitome of following the crowd. It also means a higher number of investors who tend to overreact to bigger swings in the market. Investors more sensitive to volatility are the first to yell “Fire!” in a crowded theater and start the next stampede for the exists. Once that stampede starts, someone needs to be a buyer of whatever is being sold.
(I’ve said in the past that markets will be more emotionally driven since so many more people are managing their retirement savings then in decades past. About two-thirds of investors with a 401k, manage it themselves. The over crowding into index funds and the resulting market wide volatility will be a big opportunity for the most disciplined investors that understand investor emotions can move markets in both directions.)
Gallup released a recent poll. The results claim investors won’t over react to excess volatility. That tells me, investors are getting comfortable only seeing market gains, so I won’t hold my breath.
It’s easy to say you won’t do anything when everything is rosy and the market only goes up for several years. But how will you react when you’re thrust in the middle of a market that seems to be falling apart? In other words, actions speak louder than words. In this case, inaction speaks loudest. And actions are costly.
This is why behavior is so important. Discipline and patience (and maybe ignorance) – to completely ignore the crowd or see past the nonsense – will have a bigger impact on your returns than owning the best fund or having the perfect allocation for your portfolio. Without discipline, you spend a lot of time beating yourself.
- Are Index-Fund Investors Smarter? – MarketWatch
- Why You Should Invest With Managers Who Eat Their Own Cooking – Morningstar
- 30-Year Market Forecast for 2015 – R. Ferri
- Markets Change. So Should You. – M. Housel
- Howard Marks: Origins and Inspiration (Video) – Talks at Google
- The Science Of Why You Should Spend Your Money On Experiences, Not Things – Fast Company
- Why are Interest Rates So Low? – B. Bernanke, Part 2, Part 3
- How Inflation Swindles the Equity Investor (Fortune Classics, 1977) – W. Buffett
- Renegades of Junk: The Rise and Fall of the Drexel Empire – Bloomberg