Wouldn’t The Markets Collapse If All Investors Were Passive?

wouldn't the markets collapse if all investors were passive?If you’ve ever read any portion of our blogs, emails, or client communications, you know we believe in a patient, long-term approach to capturing expected returns. People have come to refer to such an approach as “passive” (as opposed to active attempts to beat the market). I like to think of it as “evidence-based.”

No matter what you call it, people seem to struggle to understand it. As a result, we regularly receive different forms of one question:

Wouldn’t the markets collapse if everyone were a passive investor?

The question resurfaced rather bluntly in a recent AllianceBernstein client note entitled “The Silent Road to Serfdom: Why Passive Investing is Worse Than Marxism.” The article claims that a “supposedly capitalist economy where the only investment is passive is worse than either a centrally planned economy or an economy with active market led capital management.”[1]

I hate to admit it, but there is some truth to their claims. If every investor embraced evidence-based investing, yes, markets as we know them would cease to exist. But does that put us on par with Karl Marx?

Is Passive Investing “Unfair” or Bad for the Economy?

We tend to agree with Cliff Asness’s rebuttal: “[T]he use of price signals by those who played no role in setting them may be capitalism’s most important feature. … That most of us and most of our dollars don’t have to pick stocks, or to price air conditioners, is a great benefit and taking advantage of it makes us honest smart capitalists, not commissars.”

In other words, the markets only need a small crowd of active, engaged players to arrive at prices everyone can agree on. We get relatively efficient “supply and demand” pricing in our capital markets the same way as any other market around the world.

I find it interesting that the people who raise the same old objections about “free-loading” passive investors are usually the same ones whose profits fall prey to market forces created by those of us who want to avoid hyperactive trading costs.

As Morningstar’s John Rekenthaler observed: “Whenever active investment managers write about indexing, the suspicion arises that they arrived at the conclusion first, then searched for their reasons later. This AllianceBernstein paper does nothing to change that view.”

How Many Passive Investors Is too Many?

There is no definitive answer of how many active investors are required to set reasonable trading prices. Larry Swedroe explains that passive investors “receive all the benefits from the role that active managers play in making the financial markets efficient without having to pay their costs. In other words, while the prudent strategy is to be a passive investor, you don’t want everyone to draw that conclusion.”

Still, Swedroe suggests that “at least 90% of the active management industry could disappear and the markets would remain highly efficient.” Vanguard founder John Bogle (who launched the world’s first public index fund) arrived at the same number. Burton Malkiel (author of the classic A Random Walk Down Wall Street) has set the number even higher.

“[W]hen indexing is 95 percent of the total, I might start to worry about that,” he says in this podcast interview (at around 1:03:30). “But I think with indexing [at] 30 to 35 percent of the total, there is still plenty of active managers out there to make sure that information gets reflected quickly. And in fact I think it’ll always be the case.”

What Are the Chances That We’ll Reach the Tipping Point?

But what if all of the professionals are wrong? What if the market’s wheels need to be greased with more active players than we’re suggesting?

We’re not too worried. Investors like us are far from the majority.

Swedroe observes of the U.S. markets: “Despite their growing share of the market (passive funds now control perhaps one-third of all assets under management), they still account for only a small percentage of trading activity. According to a Vanguard spokesman, on a typical day, only 5–10% of total trading volume comes from index funds.”

In other words, the active traders are still active enough to enact effective pricing, and there’s no reason to think that’ll end anytime soon.

Behavioral finance is alive and well

Investors are still only human, and humans are still largely driven by emotion and instinct, neither of which has anything to do with solid evidence and rational decisions. Just look at how investors chase trends and run for the hills at the first sign of risk. They’re regularly at the mercy of behavioral traits such as herd mentality, recency and tracking-error regret, and that’s reflected in the market’s prices. That’s active investing, and it’s still hugely popular, among individual and institutional investors alike.

Capitalism is also alive and well

“Active” and “passive” investing represent two ends of a vast spectrum. An exclusively passive investor would simply buy and hold the entire market, accepting its returns. An exclusively active investor would constantly be seeking profitable trades by predicting future prices.

In reality, most investors are not completely on either end of the spectrum, instead opting for a mixture that is often more one or more the other, especially in global markets. Price-setting participants will remain a large part of the markets, regardless of what we call them.

As Malkiel observes: “That’s the wonderful thing about capitalism. If you have free markets and somebody can jump into the markets if there is an opportunity, you can count on the fact that somebody will. … If in fact it was the case that markets were getting less and less efficient in reflecting information, believe me, there would be a profit motive for somebody to jump in.”

Evidence-Based Investing in Capital Markets

So where does that leave us evidence-based investors? Well, as humans, we must accept that our own instinct and emotions can’t inform our strategy. So we turn to the evidence to tell us how we can effectively manage our money in markets with mostly fair prices.

What does the evidence tell us? Practically speaking, it says that generating long-term returns requires a patient approach that is focused on managing risks, minimizing unnecessary costs, and avoiding behavioral traps.

If we can help you invest according to these and similar principles – if we can serve your highest interests and personal financial goals – we believe you can expect that the capital markets will continue to serve you well, as well.




[1] As the note appears to have been released as a private, client-only distribution, we must rely on second-hand commentary as our guide.

 

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