Author Topic: Are passive index investors the parasites of the investing world?  (Read 5314 times)

peterpatch

  • Stubble
  • **
  • Posts: 101
Do the benefits of passive index investing into large diversified whole markets of financial assets (like a cap weighted world stock market ETF) dissipate as the ratio of passive to active investors increases?

What would likely happen to passive investors in a hypothetical situation where 95-100% of all stock investors in the world followed a passive indexing strategy?

Doesn’t it seem logical that passive investors are “free riders” on the aggregate achievements of active investors? Since active investors are the ones who, on the whole, cause most price movements doesn’t it follow that passive investors need them sort of like a tape worm needs a host in order to thrive and survive? Passive indexers, of which I am one, seem to use the “wisdom of the crowds” method (whether they know it or not) to generate long-term returns. Passive index investors appear to get the net benefit of the markets pricing decisions while largely avoiding the average costs of obtaining these benefits, which in economics is known as the free rider problem. Over time passive investors beat active money because they are the average of all active investing money minus the costs. Therefore compounding  those cost savings slowly allows them to crush active investors while simultaneously requiring that those same active investors flourish so they can ride their aggregate coat tails.

Anyone have a better theory on why passive indexing works so well over long periods of time?
« Last Edit: August 11, 2015, 06:11:39 PM by peterpatch »

fb132

  • Guest
Re: Are passive index investors the parasites of the investing world?
« Reply #1 on: August 11, 2015, 07:18:15 PM »
The regular Joe who invests his money panics when the market crashes, so he sells his shares, but when the market is on a hot streak, regular Joe loves to invest....that is why passive index investors work so well over long periods of time, because he or she doesn't do the same bonehead mistakes that people like regular joe does. I heard so many stories in 2008 of people who freaked out over the crash and withdrew their investments. Had they stayed in the game, they would of not only got their money back, they would of made money, period.

forummm

  • Walrus Stache
  • *******
  • Posts: 7357
  • Senior Mustachian
Re: Are passive index investors the parasites of the investing world?
« Reply #2 on: August 11, 2015, 07:20:00 PM »
There have been a number of discussions here about this topic. The summary is that it's essentially impossible to ever get that high of a percentage of assets to be passive indexing. And that passive indexing isn't a bad thing for financial markets. It's a bad thing for brokerages that make fees from lots of trading and for active managers that make fees from managing money. But I'm not very worried about those people.

peterpatch

  • Stubble
  • **
  • Posts: 101
Re: Are passive index investors the parasites of the investing world?
« Reply #3 on: August 11, 2015, 07:38:07 PM »
The regular Joe who invests his money panics when the market crashes, so he sells his shares, but when the market is on a hot streak, regular Joe loves to invest....that is why passive index investors work so well over long periods of time, because he or she doesn't do the same bonehead mistakes that people like regular joe does. I heard so many stories in 2008 of people who freaked out over the crash and withdrew their investments. Had they stayed in the game, they would of not only got their money back, they would of made money, period.

What you are describing is discipline. What I am asking is why the indexing strategy works. For example if one had the same discipline of not getting freaked out and just invested in their favourite single stock each month they'd probably, on average,  lose to an index despite doing it with regular unfailing discipline.

peterpatch

  • Stubble
  • **
  • Posts: 101
Re: Are passive index investors the parasites of the investing world?
« Reply #4 on: August 11, 2015, 07:40:27 PM »
There have been a number of discussions here about this topic. The summary is that it's essentially impossible to ever get that high of a percentage of assets to be passive indexing. And that passive indexing isn't a bad thing for financial markets. It's a bad thing for brokerages that make fees from lots of trading and for active managers that make fees from managing money. But I'm not very worried about those people.

I understand that it would be virtually impossible but was wondering what the effects, if any, would be on passive investors as the ratio of passive to active goes higher.

forummm

  • Walrus Stache
  • *******
  • Posts: 7357
  • Senior Mustachian

peterpatch

  • Stubble
  • **
  • Posts: 101
Re: Are passive index investors the parasites of the investing world?
« Reply #6 on: August 11, 2015, 08:44:36 PM »
I think it is a net negative for passive investors as the ratio of passive to active goes up. Fewer active market participants means less potential for prices to reflect all available information. It also means less very smart big money managers to collectively allocate capital in an aggregately efficient way. It also reduces the available pool of people to monitor and govern the underlying ownership positions that the stock market represents (assuming the passive investors will ignore any opportunity to vote on their shares).

Heckler

  • Handlebar Stache
  • *****
  • Posts: 1346
Re: Are passive index investors the parasites of the investing world?
« Reply #7 on: August 11, 2015, 10:21:14 PM »
I've been very, very passive, buying mutual funds since 1996, but never looking at or changing them until my employer changed providers and I was forced to change funds. Only in the past year have I found the way of reducing my costs through index ETFs.

I'm sure I'm not the only one out there who didn't  buy stocks.

ScroogeMcDutch

  • 5 O'Clock Shadow
  • *
  • Posts: 86
Re: Are passive index investors the parasites of the investing world?
« Reply #8 on: August 12, 2015, 01:16:39 AM »
Suppose there was a world, called Passiva, where only passive index investors existed. They buy fragments of the entire stockmarket based on whatever funds they have left over during accumulation phase and sell off during their early retirement phase. Price of the stock is based solely on the supply and demand from the passive investors, so those that get their money in when most people are retired tend to get a bargain deal, while those that get money in while more people are getting money in are getting the stick. There are bigger winners and losers, because in the end, it's a zero-sum game.

In such a world, a contrarian strategy would crush the passive investors, as it would be easy to play the markets for a higher return. Even better if you could pick single stocks that have a better underlying business model, more fit to survive and start differentiating on price. The transaction costs would be a small price to pay in such a game-theoretically world ripe for the slaughter.

In an opposite world, with a thriving active trading community, the passive strategy would beat or match the sum of all active strategies, because you cut out the transaction costs.

This all suggests there is an equilibrium between active and passive. If a market is too active (which I would say, our markets are) then passive will beat active. If it is too passive, then active will beat passive. If they are at their equilibrium point, then results will be about equal. My guesstimate is you would need about 80% passive for active to start beating passive in general. But that is really on gut feeling - if 20% of the market would respond to news, information, and be able to play the supply demand game, then the passive strategy would start to fail from my point of view. But it would probably still not fail massively.

PaulMaxime

  • Stubble
  • **
  • Posts: 189
  • Age: 55
  • Location: San Francisco, CA
  • Absolute power doesn't corrupt, it reveals.
Re: Are passive index investors the parasites of the investing world?
« Reply #9 on: August 12, 2015, 02:30:09 PM »
The regular Joe who invests his money panics when the market crashes, so he sells his shares, but when the market is on a hot streak, regular Joe loves to invest....that is why passive index investors work so well over long periods of time, because he or she doesn't do the same bonehead mistakes that people like regular joe does. I heard so many stories in 2008 of people who freaked out over the crash and withdrew their investments. Had they stayed in the game, they would of not only got their money back, they would of made money, period.

I don't know if I believe that. Index investors are subject to the same weaknesses of human behavior as anyone else. Perhaps it's a bit easier to stay the course, but you can bet that people in index funds were going to cash in 2008-2009 and didn't get back in for years.

brooklynguy

  • Handlebar Stache
  • *****
  • Posts: 2207
  • Age: 38
Re: Are passive index investors the parasites of the investing world?
« Reply #10 on: August 12, 2015, 02:58:10 PM »
I wouldn't call us indexers parasites.  I think our symbiotic relationship with active investors is one of commensalism, not parasitism.

forummm

  • Walrus Stache
  • *******
  • Posts: 7357
  • Senior Mustachian
Re: Are passive index investors the parasites of the investing world?
« Reply #11 on: August 12, 2015, 03:17:06 PM »
commensalism

That's the word of the day folks!

Quote
com·men·sal·ism
kəˈmensəˌlizəm
noun BIOLOGY
an association between two organisms in which one benefits and the other derives neither benefit nor harm.

davisgang90

  • Handlebar Stache
  • *****
  • Posts: 1222
  • Location: Roanoke, VA
    • Photography by Rich Davis
Re: Are passive index investors the parasites of the investing world?
« Reply #12 on: August 12, 2015, 05:07:27 PM »
I believe it is more accurate to say that financial advisers are the parasites of the investing world.

neil

  • Stubble
  • **
  • Posts: 215
Re: Are passive index investors the parasites of the investing world?
« Reply #13 on: August 12, 2015, 05:45:12 PM »
What do you think active investors are achieving?  I don't know why hundreds of billions of dollars need to be moved around daily to maintain the purpose of stock as a financial instrument.

Human beings with finite life spans tend to add to the pot when accumulating and take from the pot after retirement.  Do you consider the retirees parasites?

peterpatch

  • Stubble
  • **
  • Posts: 101
Re: Are passive index investors the parasites of the investing world?
« Reply #14 on: August 12, 2015, 06:00:59 PM »
I believe it is more accurate to say that financial advisers are the parasites of the investing world.

I think you're using too broad a brush there. Many financial advisers provide valuable planning advice , particularly for complicated situations like tax minimization and trusts. On top of that some financial advisers use cheap index funds and charge reasonable fees to essentially keep their clients on a steady path to wealth by influencing them to stay the course through good and bad times. I would hardly call all advisers parasites, but some of them do cause harm to their clients to their own benefit.

Most stock brokers on the other hand are by-and-large parasites who will churn your portfolio like crazy to maximize commissions if you give them the chance.

peterpatch

  • Stubble
  • **
  • Posts: 101
Re: Are passive index investors the parasites of the investing world?
« Reply #15 on: August 12, 2015, 06:02:03 PM »
commensalism

That's the word of the day folks!

Quote
com·men·sal·ism
kəˈmensəˌlizəm
noun BIOLOGY
an association between two organisms in which one benefits and the other derives neither benefit nor harm.

If I had that word in my vocabulary I would have used it instead of parasite. You must kick ass in scrabble.

peterpatch

  • Stubble
  • **
  • Posts: 101
Re: Are passive index investors the parasites of the investing world?
« Reply #16 on: August 12, 2015, 06:13:24 PM »
What do you think active investors are achieving?  I don't know why hundreds of billions of dollars need to be moved around daily to maintain the purpose of stock as a financial instrument.

Human beings with finite life spans tend to add to the pot when accumulating and take from the pot after retirement.  Do you consider the retirees parasites?

The active investors keep prices reasonable because they do things like analyze the underlying business and try to buy when price is below their estimate of intrinsic value. Other times the active investors use something called arbitrage to make money by trading the same security in different markets. There are many active strategies that get employed by many very smart people who have way more data, computing power and brains than any of us can hope to have at our disposal. They are necessary for passive investors to thrive because passive investors accept the market average which is the collective investing wisdom of the whole stock market distilled into the price of the market. I was wondering what the effects are on passive investors as the ratio of passive to active investors increases. Is there a steady linear degradation or is it more of an exponential degradation as the ratio approaches 100%?

As more and more people are moving to passive investments do we need to worry about degradation due to too many free riders? My guess is that we can always count on greed to keep the ratio well below 100% , however can we count on it enough to keep passive investing as predictably profitable as it has been in the past. It's only really been around since Bogle invented it which is something like 50 years, it's an experiment that hasn't been run before.

peterpatch

  • Stubble
  • **
  • Posts: 101
Re: Are passive index investors the parasites of the investing world?
« Reply #17 on: August 12, 2015, 06:32:02 PM »
Suppose there was a world, called Passiva, where only passive index investors existed. They buy fragments of the entire stockmarket based on whatever funds they have left over during accumulation phase and sell off during their early retirement phase. Price of the stock is based solely on the supply and demand from the passive investors, so those that get their money in when most people are retired tend to get a bargain deal, while those that get money in while more people are getting money in are getting the stick. There are bigger winners and losers, because in the end, it's a zero-sum game.

In such a world, a contrarian strategy would crush the passive investors, as it would be easy to play the markets for a higher return. Even better if you could pick single stocks that have a better underlying business model, more fit to survive and start differentiating on price. The transaction costs would be a small price to pay in such a game-theoretically world ripe for the slaughter.

In an opposite world, with a thriving active trading community, the passive strategy would beat or match the sum of all active strategies, because you cut out the transaction costs.

This all suggests there is an equilibrium between active and passive. If a market is too active (which I would say, our markets are) then passive will beat active. If it is too passive, then active will beat passive. If they are at their equilibrium point, then results will be about equal. My guesstimate is you would need about 80% passive for active to start beating passive in general. But that is really on gut feeling - if 20% of the market would respond to news, information, and be able to play the supply demand game, then the passive strategy would start to fail from my point of view. But it would probably still not fail massively.

I really liked that answer, thank you.

I wonder if it would be possible to simulate a stock market, on a computer, and adjust the ratio of passive to active investors to see where that equilibrium approximately is. Personally I think the equilibrium would be around 40-50%. for example once active investors realize they can count on indexers to auto buy/sell titanic blocks of stock based on the rules of an index they can easily front run what goes on and off the indexes to make some money, although the very act of this front running will drive prices to reasonable values eventually. I guess if you are extremely well diversified and holding a world index of financial assets (bonds, stocks , REITS, TIPS, etc.) then you'd largely avoid this because you'd be holding a little bit of everything (your only risk would be doing badly in bad times). Looks like passive accounts for about 17% of investors worldwide and 21% of investors in the US so I'm not too worried at the moment.
« Last Edit: August 12, 2015, 06:33:46 PM by peterpatch »

peterpatch

  • Stubble
  • **
  • Posts: 101
Re: Are passive index investors the parasites of the investing world?
« Reply #18 on: August 12, 2015, 06:44:58 PM »
  Do you consider the retirees parasites?

I was using the word parasite as a metaphor, not meaning to offend anyone.

neil

  • Stubble
  • **
  • Posts: 215
Re: Are passive index investors the parasites of the investing world?
« Reply #19 on: August 12, 2015, 07:05:42 PM »
I am aware of what most active traders do.  In fairness, I was probably trolling a bit.  The retiree reference was not accidental - there are studies that attempt to measure the impact of an aging population on returns since this is something we are currently facing.  It is not hard to imagine what stock prices do when the overall cash flow is negative.

What is the role of index funds?  Decades-long stock-based return characteristics for people who only need average return.  Does everyone have this goal?  I don't think so.  But it defines the main goal of retirement funds and retirement income very well.  By trading, I am constantly exposing myself to the short term.  I do believe people do this successfully.  I think for the vast majority of retirement accounts, this is the best answer.  But some people have goals with shorter timelines, and some entities are not actually people with limited lifespans.

I think when you turn this discussion to a different asset class like municipal bonds, people would rarely suggest buying one town's debt over another.  I guess I don't understand why the answer is fundamentally different.  You can probably argue that it is easier to generate alpha in the bond market because of this, and you are probably right.  But then, I might come to the inverse conclusion that it is hard to generate alpha in the stock market because people allocate too much attention to it. 

deborah

  • Walrus Stache
  • *******
  • Posts: 8236
  • Location: Australia or another awesome place
Re: Are passive index investors the parasites of the investing world?
« Reply #20 on: August 13, 2015, 04:27:32 AM »
Micro-traders are the parasites.

MetalCap

  • Stubble
  • **
  • Posts: 113
  • Location: Washington DC
Re: Are passive index investors the parasites of the investing world?
« Reply #21 on: August 13, 2015, 06:11:25 AM »
I think that this misses a third sector of stock owners; the ones who are the "Owners" (majority shareholders) of certain companies.  Like Zuckerburg and Page and even small traded companies, there are people who have major holdings in just one or two companies.  While they may do some tradings, their focus is the performance of a single company and they will rarely give up that position.  This base of all stock holdings by these majority owners will negate the problems of a large indexing population because it prevents indexers from holding too much (majority) of any one company.  The individual level prevention will therefore prevent this from becoming an issue at the macro level.

peterpatch

  • Stubble
  • **
  • Posts: 101
Re: Are passive index investors the parasites of the investing world?
« Reply #22 on: August 14, 2015, 05:38:00 PM »
I think that this misses a third sector of stock owners; the ones who are the "Owners" (majority shareholders) of certain companies.  Like Zuckerburg and Page and even small traded companies, there are people who have major holdings in just one or two companies.  While they may do some tradings, their focus is the performance of a single company and they will rarely give up that position.  This base of all stock holdings by these majority owners will negate the problems of a large indexing population because it prevents indexers from holding too much (majority) of any one company.  The individual level prevention will therefore prevent this from becoming an issue at the macro level.

You may be right. However stocks are priced at the margin, therefore prices are determined by the people buying and selling. If your third sector will truly never sell their stock then they are mostly irrelevant direct market participants. However if they are operating the business, like Zuck, then they have significant second order effects on the stock market through their influence. Dividends are usually paid based on underlying business performance which is another area that would more consistently pay shareholders a return regardless of passive vs. active ratio.