What if everyone did it? ETFs/Indexfunds and conformation bias

[dachs]

Hello,

the more I learn about investments the more I wonder if I'm suffering some sort of confirmation bias*. Ever since I found out about MMM and index fund investments I read a lot about that topic, however, most books and articles are recommended by people who also think that index investing is the best form of investments. What are your thoughts on this?

One thing I've learned so far is that what everyone seems to be doing might not be the best thing to do since that might lead to a bubble or something like that. And index investing seems to be just that, everyone seems to be recommending it.

So what makes you think that following that strategy will work out in the future? I've tried to put together points that make sense to me and why they might not work so well as well.

1) Investments in companies that make money seems to be a very reasonable approach to make money as well. That’s why stocks will probably a good investment in the future.

- Well, that might be true but it also depends on how much you have to pay for those companies. Otherwise it would be the best way to just buy the company that makes the most money and that doesn’t work out for obvious reasons.

2) Stocks will outperform other asset classes in the long run because they are riskier and thus have an equity premium. It’s the same with small stocks, they are riskier and that is why they outperformed large stocks in the past.

- That kind of makes sense to me, but what if the general public gets the idea that investing in index funds has been a great way to make money in the long run and thus stock prices will be relatively high which will lower the returns? If lot’s of people jump on that „oh, stocks are low, I’ll buy more stocks now“ train stocks will never really get low until some huge bubble bursts. And if everyone buys small cap stocks they might not perform that well either.

3) There will always be people who think that they can outsmart the market (and some can do that for some time).

- Well, I hope so because otherwise index investing doesn’t make much sense since the market will be inefficient. Might it be true that in a very efficient market the best way to make money is index investing but if everyone did index investing only the market would become highly inefficient?

4) In the end it’s important to diversify, so stocks might outperform (and probably will) other asset classes but there is no guarantee to that. So the best way is to create a reasonable mixture of different asset classes and stick to it.

- That will probably be my approach. However, since my stash is not that big yet it doesn’t make sense for me to invest in 7 different asset classes plus subcategories for each of those.

So what do you guys think about that?

*http://youarenotsosmart.com/2010/06/23/confirmation-bias/

[nobodyspecial]

The price of stocks is set by what people are willing to sell them for.
There is a problem if the entire market is ETFs, there is no liquidity and so no price. This was much more of a problem 50-100years ago when only the wealthy invested.
In the unlikely event that the stock market ends because Vanguard owns America then you can still signal your company's value with dividends based on profit.

Global capitalism also fails if nobody has any debt, another mustachianism, but not something people seem to worry about.

4) In the end it’s important to diversify, so stocks might outperform (and probably will) other asset classes but there is no guarantee to that. So the best way is to create a reasonable mixture of different asset classes and stick to it.

Other asset classes simply trade risk for reward. From negative rate Japanese govt bonds to the street corner casino offering you a chance to find the lady. There is plenty of diversity of risk/reward in the stock market if you want to pick individual stocks

[dachs]

The price of stocks is set by what people are willing to sell them for.
There is a problem if the entire market is ETFs, there is no liquidity and so no price. This was much more of a problem 50-100years ago when only the wealthy invested.
In the unlikely event that the stock market ends because Vanguard owns America then you can still signal your company's value with dividends based on profit.

Global capitalism also fails if nobody has any debt, another mustachianism, but not something people seem to worry about.

4) In the end it’s important to diversify, so stocks might outperform (and probably will) other asset classes but there is no guarantee to that. So the best way is to create a reasonable mixture of different asset classes and stick to it.

Other asset classes simply trade risk for reward. From negative rate Japanese govt bonds to the street corner casino offering you a chance to find the lady. There is plenty of diversity of risk/reward in the stock market if you want to pick individual stocks

I think that other asset classes in a portfolio can lower your risk with the same or even more returns because they are not 100% correlated to each other. Isn't that the idea of portfolio theory? In this video (https://www.youtube.com/watch?v=8rTBEZSL7-4) there is an example of a portfolio that outperformed the S&P 500 in the last 40 years with a lower volatility because it was well diversified. I think the asset classes were large and small US stocks, international stocks, REITs, commodities, cash and bonds. The equally weighted portfolio did better than the S&P 500.

[nobodyspecial]

I wasn't thinking of different stock markets as different asset classes - so I was having difficulty thinking of 7 different asset classes that a person could hold. Stocks / bonds / cash / precious metals / real estate,  then ....

There are a bunch of asset classes, or collections of assets that have done better than the SP500. Original Apple 1 motherboards, first Harry Potter novel first edition, certain Congolese diamond mine leases - the trick is spotting them in advance, not looking back
     

[Seppia]

All that's said makes a ton of sense on paper, then every so many days a massive blue chip company misses/over performs quarterly earnings and its price swings by 10% in a day, and I am reminded that logic is a very scarce resource in the markets.

[nobodyspecial]

Or a massive blue chip company carries on doing the same money losing activities (IBM, HP) and doesn't drop 10%
 

[Seppia]

IBM was over $200 not so long ago if I'm not mistaken btw