If Everyone Indexed - A Fantasy

Last Updated Jul 24, 2011 3:14 PM EDT

I'm very appreciative of the many active investors who have given us indexers a "free ride." Remembering my manners, I've been sure to thank them, and even argued that Mad Money's Jim Cramer deserves a raise. After all, it's the active investors who pay to keep the market efficient. But what if they stopped? What if everyone became a broad stock index investor?

Would Markets stop working?
When I started thinking about this fantasy, my first thought was that markets would stop working. If everyone owned the broad index funds then all stocks would be owned by those index funds. I imagined that stock trading would stop dead in its tracks, as low cost broad global index funds would own every equity.

Funny thing is, that I've actually had several people tell me to stop spreading the word on low cost indexing so it doesn't ruin a good thing. My response is that human nature and Wall Street would never let that happen. I then note that, even if I'm wrong on this assumption, it actually wouldn't change a thing in capital markets.

Exploring the fantasy
Let's take this fantasy for a ride and pretend that everyone was an indexer going into 2010. Every public company in the world is now owned by broad index funds. Now let's look at only two companies:
    • Apple, Inc., which launched the latest blockbuster product - the iPad. It's such a revolutionary product that I actually bought one and love it. Cash flow for Apple skyrocketed.
    • British Petroleum, which everyone on the planet knows had a disaster costing them an estimated $20 billion, not to mention damages from its brand being tarnished.
In this fantasy, one might think that neither Apple shareholders would be rewarded nor BP shareholders punished. Since all of their stock is owned by index funds, none of those funds would have traded a single share of any stock.

Why I'd abandon indexing
I've clearly got the scarlet "I" for indexing tattooed on my forehead but, in this scenario, even I'd sell my index funds and start buying undervalued stocks like Apple and avoid overvalued stocks like BP. Remember, neither stock had changed in price.

You might wonder who'd sell me the undervalued stocks like Apple? Well when I sell my index funds, the index funds must sell the stocks to raise the cash to redeem my shares. Along with many other investors, I'd be buying up the undervalued stocks which, of course, would cause their stock prices to increase.

Because the index funds must sell every stock in the index to raise the cash to pay investors like me, that means they'd have to sell the underperforming companies like BP. Since BP isn't worth the price it started the year with, I wouldn't buy it, and neither would any of the rational investors. But the index fund would have to sell it and I'd be a buyer at a much lower price. That, of course, would be the same as with any rational investor.

Back to the future
Where we end up is exactly where we are now. Because even indexers like me would rather sell the BPs and buy the Apples, stock prices would be moving again. Markets would again be efficient and I'd turn back to indexing.

The purpose of my fantasy
Okay, so maybe one purpose was to have a little fun imagining what can never happen. But another purpose is to assure indexers that we will always have the free ride given to us by active investors. We don't need to count on traders continuing to not understand the arithmetic of active investing that guarantees them lower returns.

In the unlikely event of active investors becoming logical, indexing will still work just fine. So go ahead and tell everyone about indexing. The success of indexing stands on its own logic and is not dependent upon the Jim Cramers of the world.

Note: Image from wallcoo.net.
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    Allan S. Roth is the founder of Wealth Logic, an hourly based financial planning and investment advisory firm that advises clients with portfolios ranging from $10,000 to over $50 million. The author of How a Second Grader Beats Wall Street, Roth teaches investments and behavioral finance at the University of Denver and is a frequent speaker. He is required by law to note that his columns are not meant as specific investment advice, since any advice of that sort would need to take into account such things as each reader's willingness and need to take risk. His columns will specifically avoid the foolishness of predicting the next hot stock or what the stock market will do next month.

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