Setting Warren Buffett aside, what you neglect to mention is that the stock market is both a primary and secondary capital market. We can speculate about how to speculate... whether to be passive or active... but this concerns only the functionality of the secondary market. There's still primary market functionality: companies issue stock to raise capital, buyback stock, and issue dividends. Thus, even if all the investors are passive, there's still always one active agent in the game: the company itself. And a capitalization-weighted index is ideally suited for this activity: it automatically shifts capital away from companies buying back stock (essentially, companies returning money to investors) to those issuing new stock (essentially, companies seeking to raise capital).
The bet was simple. Buffett would invest in a Vanguard S&P 500 index fund, and the hedge fund could do anything they wanted.
http://fortune.com/2016/05/11/warren-buffett-hedge-fund-bet/
http://www.npr.org/2016/03/10/469897691/armed-with-an-index-...
His biggest returns for the first 3/4 of his adult life involved him going against the market when equities were out of favor and scooping up extremely large positions in the likes of The Washington Post, GEICO, American Express, Wells Fargo and Coca Cola.
His extraordinary history of stock picking is what enabled him to begin buying entire substantial businesses in the first place. The stock picking is what accumulated the capital necessary to buy Blue Chip Stamps and See's Candies. The Buffett partnerships for example were not built around buying up entire businesses and operating them for decades to reinvest the cash flow, and yet his returns were dramatic - regularly stomping the Dow - during those years precisely because he was such a great stock picker.
The advantage he had in the GS preferred stock offering in 2008 was his ability to provide liquidity and his name - if GS told people that Warren was investing in them then it was a real vote of confidence.
When full ownership is taken (his preferred option), the original management is almost always left in place. No rules or guidance are given. The subsidiaries work however they worked before acquisition.
That said, after reading through his 50 Berkshire Hathaway letters, the main lesson I drew was: own insurance companies which underwrite for profit under all economic conditions.
The Bank of America deal shows how good a deal you can get when you can put $5B where your mouth is
> In exchange, Berkshire Hathaway received $5 billion worth of preferred stock yielding 6% a year plus warrants to purchase 700 million shares of Bank of America common stock at an exercise price of $7.14 per share.
apologies in advance for linking to fool.com http://www.fool.com/investing/general/2015/08/19/how-much-is...
It helped that they were structurally inclined to build up cash. As Buffet explains, a booming share market is bad for him: everything is too expensive to buy.
So cash piles up, waiting for good deals of sufficient magnitude to arise.
When a bust arrives, there are bargains everywhere and a lot of money to buy into them.
Buffett gets to do deals (on better terms no less) that others can't as a result of his celebrity and this has been the case for a long long time.
[1] In the same way Trump has but with a much better track record.
A good troll would have been to buy Berkshire Hathaway.
Ugh. Now we have npr teaches "law of averages" backwards
https://www.bloomberg.com/view/articles/2012-04-24/what-was-...
http://www.forbes.com/sites/randalllane/2012/03/26/warren-bu...
https://www.quora.com/What-was-the-fee-structure-of-Warren-B...
Won't the "tracking fee" of the index funds keep increasing, as a larger and larger fraction of the market is covered by them? Whenever a stock rises to X$, billions' worth of index funds will rush to buy the stock to rebalance their holdings, but clearly that should further raise the price of the stock (and they'll have to buy it at X+0.10, or X+0.50).
If a stock goes up, they don't need to buy more of it - the value of the shares they hold will increase to exactly the right proportion that they should have.
(There do exist other types of funds which try equally weight the stocks they hold, which means the fund has to rebalance when the stocks change price.)
Typically, cap-weighted funds only have to rebalance when individual members of the fund buy/sell - and they try to make it so people are buying/selling to those within the fund where possible to avoid having to do even that. The result is a very low churn, which is part of why index funds have lower fees.
Usually, the more assets an index fund has under management, the lower an index fund's fees get.
EDIT: and doesn't my above argument hold at the boundary? When a stock is brought into the S&P, suddenly all of the index funds need to stock up on it, further bolstering its price, no?
You're correct about what happens at the boundary, yes.
There's a well-known arbitrage opportunity for stocks that are known to be about to be brought into the S&P 500 (their prices DO tend to increase, I believe), if you want to research that. Like all publicly known arbitrages, I doubt you can make any money off it personally anymore though.
This is part of why the recommendation is not to use an S&P 500 fund, but something more like Vanguard's Total Stock Market fund, which includes medium/small-cap companies. Not that it's a huge deal, though - mutual fund companies are usually pretty clever about spreading large orders out over time.
So while it's still possible to raise capital by printing stock, this is happening less and less lately.
http://www.theatlantic.com/politics/archive/2015/02/kill-sto...
EDIT: Or, to put it in EHM analogy terms, the number of people looking for loose change on the sidewalk will go down until there are few enough to support themselves from the money people actually drop.
So somebody might purchase an index fund and think they are investing passively, they are really actively choosing a passive strategy.
In the current situation, 34% of the money passively follows the active investors. That gives the active investors a 34% amplifier in their action.
I'd say the possible bad news is that the larger the passive pool, the less capital it takes to manipulate a stock price.
Seriously, index fund investing assumes an optimistic outlook. It assumes the managers of companies will do an OK job in the long term and the companies will grow. Index funds allow investors to participate in that growth without having a big chunk of it going into Mr. Johnson's pocket. A low fee burden turns OK company performance into acceptable retirement savings growth.
It's not a zero sum game. It's a slightly-positive-sum game. That means a lot of people can play and slightly win.
As for pricing the equities, the fundamental qualities of the businesses behind them are, even in the stock market casino of the 21st century, still important. Warren Buffet understands fundamentals. There's no reason a market dominated by index funds must ignore them.
There are two other aspects of successful index investing.
1. Diversification. Don't put all your money in one index. What if you have all your money in the NASDAQ index when the cultural narrowmindedness of Silicon Valley (the rule of young white brogrammers) catches up with them?
2. Disciplined rebalancing. Set a goal for diversification percentages: 60% growth equities, 20% growth-and-income, 10% nonUSA, 10% bonds for example. When your investment values move away from those percentages, sell the excess in one category and reinvest it in the other categories. This amounts to buy-low sell-high. It will serve as a ratchet to capture the upside and limit the downside.
Panic buying and selling is for the other guy. I'm grateful to that other guy; he's helped me set up a nice 401k balance.
It's more important to choose an allocation strategy and stick to it than it is to select the perfect allocation strategy.
Here's the hard part: determine your household's tolerance for risk. Are you willing to sit tight and not panic-sell if one or two of your funds decline by 40% in value? 20%? It's hard to know for sure how you will react until it happens. But, a decline like that means you should buy, not sell.
I mention "your household" because your spouse or other relatives might influence your risk tolerance. It doesn't matter if your anatomy is solid brass if your spouse insists on panic-selling. Part of the deal with risk tolerance is having conversations with family stakeholders about risk, to prepare for the inevitable downturn.
As the time grows nearer when you need to use the funds in your portfolio (retirement? college tuition?): reduce your stated risk tolerance once a year or so, and rebalance accordingly. This will help you lock in your gains even if something bad happens.
In the old, pre-junk-bond, days, "bonds" were considered lowest risk, "growth-and-income stocks" medium risk, and "growth stocks" highest risk. You can probably find index funds like those. Certainly you can find funds that invest in an index basket of low-risk bonds, or an index basket of dividend-paying (growth and income stocks).
"Unmanaged" is the key word to identify index funds. Vanguard, DFA, and others are the companies offering them.
One last thing: If you don't understand a fund's strategy, DO NOT INVEST IN THAT FUND. If the promises seem too good to be true, well....
But for example I've got a ton of money in cryptocurrency right now, it's my field and I've got way better-than-average knowledge about some of the coins. This helps me make informed investments, and I've been able to beat the passive rate by doing high risk investing into assets that were obviously priced incorrectly.
I'm not a day trader. I'm like the guy who goes about his way normally, but isn't afraid to pick up $20 off the ground when I see it. I spend some time looking for it, but it's not where I put most of my energy.
I doubt you mean that you actually have knowledge of when and how the price is going to change. Are you just betting on a general increase in value, or doing some form of pairs trading or arbitrage? How comfortable are you with rapid 30% price swings?
I've yet to be bold enough to short something overpriced but there are plenty of cases where something has struck me as obviously overpriced and within a year the price has corrected.
Game plan definitely involves waiting months at a time.
1. Some people will beat the market, and regardless, someone has to try or there's a massive opportunity left on the table.
2. Indexing actually has more of a certain type of risk than passive investing, because if you take a huge loss for some period of time, you can't hedge it and cut the short term loss. You have to just hold. Active investing can be really valuable for folks as they enter phases of their life where big losses are unacceptable and they're willing to forgo some of the upside.
That is not quite right. When entering retirement, most people can expect to live for at least 20 more years, which means they should hold a non-insignificant fraction of their wealth in stocks.
Further, those who find themselves in the fortunate situation of being overwhelmingly likely to leave a significant estate to their children should consider investing their funds according to the life expectancy of the children, not their own.
"The stocks were often described as "one-decision", as they were viewed as extremely stable, even over long periods of time.
The most common characteristic by the constituents were solid earnings growth for which these stocks were assigned extraordinary high price-earnings ratios. Fifty times earnings was not uncommon."
So when the bogleheads endlessly debate the perfect portfolio mix, they miss the point that they have zero exposure to private equity and other markets.
Index funds are better than managed funds, and are mostly better than individual equities. That doesn't mean that 100% of your money should be in them.
This came up a couple months ago on HN [0], and to that scenario I say:
> Yeah, it's a bit like saying: "But what if all the animals in the ecosystem became helpless herbivores?"
This doesn't mean PASSIVE investors can't all do the same thing. In fact because risk over time is the fundamental reason passive investors make money, they can do exactly this. This isn't some loophole in the system. They are taking risk!!! It's amazing how many people don't understand this.
(edited)
What could possibly go wrong?
https://about.vanguard.com/vanguard-proxy-voting/update-on-v...
That being said, there are all sorts of problems with the incentives here.
Yes what you say does sound worrisome.
I would argue that this is already the case.
I invest solely in market-wide or top-75%-of-market-caps strategies (in stocks), because they're the only strategies that seem to accurately reflect my opinion of the markets:
1. The game is rigged.
2. People are dumb. (Especially me.)
Analysis of those strategies seems to indicate that they outperform even (traditional) index funds over long periods (likely because they're quicker to respond to risk/opportunity during transitional periods, eg, a new technology coming out). I like to think it's because my premises are true, but there's lots of other premises that lead to the same model of investing, so it's hard to say. (I think of them as a really diverse index fund, so at some level, it's really just the advice that Warren Buffet gave about long term investing.)
If everyone used this strategy the market would... basically do nothing once a company IPO'd, because everyone would hold a portion of every company forever (creating no selling once the initial bidding on IPO was over). That's not necessarily such a bad thing, because it would remove a lot of the noise that boards respond to while still incentivizing (healthy) long-term growth (because the only way the stock increases in value without trading and the current market gambling is from the underlying asset -- the corporation -- increasing in value, and distributing that as payouts or buybacks). There still is a valuation mechanism, however, because the passive funds do need to buy and sell when new stocks appear or someone is looking to change a position (which, is every IPO plus whatever is needed to generate cashflow from the portfolio), and how they negotiate that provides a value on the stock, even if they're just rolling shares they control between pools and clients of their own.
However, we'd still have the whole pipeline of pre-IPO private ownership, which definitely wouldn't settle in to the same kind of lock-in, but already uses the same kind of invest-across-the-board strategies.
So in short, I'm actually very unworried about the effects of main Wall St stock markets settling down due to most money being passively invested in long-term growth strategies, because it actually deincentivizes a lot of bad behavior on the part of trading firms. Much harder to execute your fraud if most people aren't going to react to it in any capacity, and won't be closing out their positions for 20-40 years, if ever. It's also perhaps easier to get a case to stick if you have basically every investor to choose a client from, because they'd all be impacted by those actions.
What was it Keynes said about rationality and being solvent?
^^
He said that though.