Can we discuss indexing and its pros and cons?

I've been thinking about how almost everyone with any financial know-how recommends indexing to those who maybe don't have the same savvy and I kept thinking there has to be something wrong with recommending a one-size-fits-all solution. After all, we know that every time the entire market buys into something, it eventually fails.

I started reading into it and realized that I actually had no idea how indexing worked, and I spend a lot of time teaching myself finance. For whatever reason, I assumed that an index fund was just a tracking stock for the companies in that index. I never considered that an ETF or index fund actually has to own shares in the companies they index, otherwise there are no assets for shareholders in those funds to "invest" in, they're just hoping an arbitrary line goes up.

After really learning how index funds work, I realized what the inherent problems were and reading a few different sources confirmed that this is something people much smarter than me already know.

To make this simple, let's take any run-of-the-mill S&P 500 index fund. As more and more investors buy into this fund, the fund has to go out and buy more and more stock in the S&P500 companies. Regardless how the fund decides to weight the different companies in the index, you have a situation where a large institution is buying up certain stock because they have to, not because it's a good investment.

What ends up occurring is the fund buys more S&P 500 stocks, thereby pushing up the price of companies they buy, making it look like they are outperforming (and technically speaking, they are). Investors see this and funnel more money into the index, and it has to go out and buy more of the same stocks. A positive feedback loop ensues, artificially pushing up multiples for these companies. I'm talking about the S&P 500 because it's more pronounced there, but the same could be said for other indexes that have a large following.

So the thing I wanted to discuss with you guys that are largely much more knowledgeable than I am with this stuff, is why would any financially-savvy person who has others' best interests at heart, recommend investing in an index. I mean, the gravy train has to stop at some point right? If and when it does, the indexes that were stacked the most on the way up are going to be the ones that have the most downside risk on the way down, right? Obviously the S&P 500 companies deserve a small multiple premium because of their positions, but what about when it gets blown out of proportion. For example, the current P/E ratio for the entire S&P500 is 26.01, which is about 1.6 standard deviations away from the mean. In other words, the S&P500 has historically spent 95% of its time below its current level since 1900.

You could argue that with globalization and the overall greater earning power of S&P500 companies currently, they deserve a higher multiple. I'd agree with you, but I guess the important distinction ends up being how much of a premium they deserve.

I cringe when I see someone post on this subreddit who obviously does not have the time or passion to learn about the nitty gritty details about investing in equities and a bunch of people recommend indexing. Obviously no one is wrong to recommend it, but I just can't get comfortable with the idea with indexing. I have my own opinion, but I'd like to hear what you guys have to say about this topic.

FYI, I know this discussion has occurred before (last thread was about 3 months ago), but it's an ongoing issue so there are always new viewpoints to be heard and discussed.

P.S. I've learned a ton by lurking here and really hope to keep doing so, especially when market conditions change. Obviously the 10-year bull market means the large portion of this sub (including me) has never really spent much time investing during other market conditions. I'm curious to see how my own views and the views of this sub as a community change over time.

Submitted July 17, 2017 at 06:51PM by mdcd4u2c


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