Passive investing is becoming more popular. Why?

Over the last years more money has flowed into broad-based market indices than into actively managed funds. Lots of investors now get the average stock market return for free. In 1974 Paul Samuelson, a prominent economist and Nobel Prize winner, predicted that most active funds should go out of business because even the best asset managers could not always beat the market.

Samuelson’s case for broad-based market indices rested on the idea that financial markets are efficient, in that any relevant news about a company’s prospects is quickly reflected in its share price. If there were obvious bargains, a little effort would bring riches at the expense of slothful investors.

The average investor can do only as well as the stock market average. For some investors to beat the market, others must be beaten by it. A talented few asset managers might be able to beat the market, at least a while. But if they can do so consistently, they will charge a lot to manage your money. And it is always possible that they are lucky and not skillful. The average person will not be able to tell the difference.

Some asset managers falsely argue that indexing is making the markets less efficient. For example, they say that index investing helps to inflate bubbles. As this article in the economist states, this misses the logic of a passive strategy. A market index weights each asset by its value. If a stock’s price rises rapidly, its weight in the index increases. But its value in the indexed portfolio also increases. No buying is needed!

But what if everybody does indexing? Yes, that would be a problem. And if there were no crime, policemen would be out of work. But don’t worry we are not near that point (See here for more details). If the rise of broad-based index investing means less dumb money, then it is harder to beat the market. Yet it goes against human nature for people to think of themselves as mediocre or settling for the average. People will still try to beat the market, even though failure is more likely than success.