“The average American is from Missouri everywhere and at all times except when he goes to the brokers’ offices and looks at the tape, whether it is in stocks or commodities. The one game of all games that really requires study before making a play is the one he goes into without his usual highly intelligent preliminary and precautionary doubts. He will risk half his fortune in the stock market with less reflection than he devotes to the selection of a medium-priced automobile.” -Jesse Livermore
These days, the sort of reckless financial abandon Livermore describes is on prominent display in the rapidly rising popularity of, “passive investing.” I first addressed this issue two years ago in a post titled, “one reason I’m worried about the rise of the robo-adviser,” writing:
…as this form of investing becomes more and more popular, the risk of mispricings (and even bubbles) in the markets grows with it because it completely abandons the basic process of analyzing value and risk. When you have a growing stream of buyers who are agnostic when it comes to value – meaning they will continue to buy regardless of price – it’s hard not to see problems arising.
Hedge fund manager, Bill Ackman, recently attempted to quantify the growth of this style of investing, writing, “Last year, index funds were allocated nearly 20% of every dollar invested in the market. That is up from 10% fifteen years ago.” Considering the rapid growth in this form of price-insensitive buyers, he comes to a very similar conclusion:
We believe that it is axiomatic that while capital flows will drive market values in the short term, valuations will drive market values over the long term. As a result, large and growing inflows to index funds, coupled with their market-cap driven allocation policies, drive index component valuations upwards and reduce their potential long-term rates of return. As the most popular index funds’ constituent companies become overvalued, these funds long-term rates of returns will likely decline, reducing investor appeal and increasing capital outflows. When capital flows reverse, index fund returns will likely decline, reducing investor interest, further increasing capital outflows, and so on.
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