Will You Survive The Passive Investing Bubble?


First of all, let me say that I love investing.  I really do.  The fact that you can take a few dollars, invest them, and then make even more dollars, is like a magical dream come true.

Except sometimes in investing things don’t always go smooth.  Sometimes those dreams turn into nightmares, and the investor loses both capital gains AND their initial investment.

This kind of nightmare turns into reality when big investing bubbles break.

Lately, there’s been a lot of talk on the interwebs about a new investing bubble that could be forming right under our feet — The Passive Investing Bubble.

 

A Passive Bubble?

Most experts consider passive index investing to be a pretty safe way to invest.  With the removal of active management, low costs, and extremely broad diversification, passive index investing has grown immensely in recent years.  It’s an easy way for the average Joe (or Jane) to invest for retirement.

Passive investing has gotten so popular that (according to Moody’s Investors Service) passively invested funds now account for 36% of the U.S. stock market.

It’s now “common knowledge” that if you buy index funds and dollar-cost average you’re bound to do pretty well over the long-term.  So well in fact, that I’m now frequently hearing the mantra, “stocks always go up”.

Frankly, everybody’s indexing these days.  Most personal finance blogs, news sites, and even investing books now recommend investing in passive index funds.

Actively managed funds are still dominant, but it’s not going to last long.  (Moody’s predicts passively manage funds will exceed actively managed funds sometime in 2021.)

So successful is index investing that only a few rare-individuals have dared suggest that passive investing might have a flaw — It could be building into a bubble.  These odd-ducks predicting a bubble have mostly been ignored as quacks.

the big short
Sometimes the quacks are right. If you haven’t seen The Big Short yet, I highly recommend it.

Lately though, investor Michael Burry has been talking about a passive investing bubble… and people are starting to wonder if he might have a point.  Why would they listen to him?  Not only was Burry the first to bet against sub-prime housing before the 2008 Global Financial Crisis, but he and his investors profited greatly from that disaster.

This is the true story told in the Oscar winning movie The Big Short.  If you haven’t seen the movie yet (and your even the slightest bit interested in money), I highly recommend watching it.  (FYI: The Big Short was #5 on my list of best money movies of all time)

Long story short: Michael Burry is no dummy.

 

What’s the Problem?

What exactly is the problem with index investing?  Isn’t passive index investing supposed to be more efficient and low cost compared to actively managed funds?

Absolutely!  The problem investors like Michael Burry are pointing at isn’t about fees or under-performing the market.  To put things simply, the problem is asset prices.

In efficient markets, prices are usually set by supply and demand — A selling investor asks for a price, and a buying investor offers a price.  These two prices are known in stock market parlance as the ‘Bid’ and the ‘Ask’.

In the old days this is how prices were set for stocks (a process called price-discovery), but in the index world investors aren’t setting prices — They’re saying “buy at whatever the current price is”, and leaving the price-discovery to fewer and fewer active investors.

A huge number of savers now funnel their income into index funds every month, buying stocks “at any price”.  Sometimes at even really silly prices.  This is exactly what’s been happening over the last decade, as more and more people have shifted from active funds to passive index funds.  Stock prices have risen steadily over the last decade, and many people now believe that — “Stock prices will always go up, so the price I pay doesn’t matter”.  

Meanwhile the number of active investors setting rational prices continues to shrink every year.

banana
Would you pay $10,000 for a banana? How about $0.01?  In the banana index fund, investors are willing to pay any price when they invest in bananas.

What happens when this happy little cycle ends and a large number of people rush for the exit “at any price”?  The bubble breaks and asset prices decline dramatically.  In other words, a big market crash.

This might sound a little far fetched, but think back to the housing bubble of the early 2000’s.  People were buying homes “at any price” because “real estate always goes up”.  Bidding wars were pushing-up prices for almost every home on the market.  The most surprising part was that lenders were actually willing to loan people money for that lunacy.

We all know how that bubble ended.  Could passive index investing create a similar bubble?  It’s possible — a large number of unsophisticated investors buying assets “at any price”, could easily distort markets into silly prices.  The good news is: I don’t think we’re there yet.

 

How To Survive When The Passive Bubble Breaks

While I’m certainly not qualified to predict stock market bubbles, equity prices certainly don’t seem to be trading at absurd prices today.  With a TTM PE of 22, the S&P 500 index seems only slightly expensive to me (given current interest rates).  Likewise, index fund buying and selling activity does not yet constitute the majority of stock market activity.

That’s today.

It’s important to remember the financial markets are always in flux.  Interest rates can rise, economies can slow, and assets types can fall into or out of favor when the wind changes.  Under the right conditions, there is the potential for a index bubble to form.

Perhaps a few years from now a bubble will build and asset prices start to look a little silly.  How can an enterprising financially independent type person prepare for this kind of crash?

Well, if you want to “survive the madness of crowds”, the most certain way is to avoid the crowds entirely.  In other words —  Invest differently, instead of just following the passive index crowd.

What exactly do I mean by “invest differently”?

1. Keep plenty of cash on-hand.  First and foremost the best way to survive any bubble when everyone rushes for the exit, is to not need the exit.  For financially independent folks this means holding through the volatility and not relying on asset sales to fun your lifestyle.  There could be months, years, or possibly even whole decades where stock prices are depressed.  Be ready for it and keep cash on-hand to pay your expenses.  Know that it could take up to a decade before prices return to previous highs.

2.  Avoid obvious trouble spots.  This might sound completely obvious, but if index investing turns into a bubble the most certain way to avoid the bubble is to avoid the stocks that are most commonly indexed (i.e. the S&P 500).  Instead, seek out investments that are under-represented among the indexes.  Today, many people point to small-cap stocks as one example of stocks that aren’t widely indexed.

3. Diversify your asset base.  Investing fads come and go, and stocks are the ‘investing fad’ of our era.  Stocks might not always be this popular however. (In the 1970’s bonds were more popular than stocks for example.)  So play it safe by diversifying into different asset classes.  There’s lots of options to consider besides stocks — Rental real estate, bonds, REITs, MLP’s, money markets and even CD’s!  You might under-perform the indexes in banner stock years like 2019, but when the weather turns you’ll be extremely glad you diversified.

4. Contemplate the rationality of prices you pay.  While it’s currently popular to “index and forget” with index investments, I believe this is a superbly wrong-headed strategy.  All investors should think carefully about what they’re doing and only index when prices make sense.  All investors should be trying to pay intelligent prices for assets, regardless of whether that asset is an index fund, a banana, or a rental house.

 

A Passive Conclusion

While I don’t see a passive bubble today, there certainly is the potential for one to develop in the future, as a larger and larger percentage of stocks are held in index funds.  That said, the sky isn’t falling (yet).  Asset prices still look “reasonable-ish”, and I’m still holding all my index fund assets today.

I consider dire warnings by smart folks like Michael Burry a “canary in the coal mine”.  They’re probably too early.

Index funds are still the easiest way for the average investor to invest in a broadly diversified portfolio of stocks at extremely low costs.  In most cases, index funds are even going to out-perform actively managed funds.  That’s still a pretty decent deal.

With that said, investors shouldn’t just cover their eyes and “hope for the best”.  Keep your eyes open and pay attention!  Blindly ignoring the stock market is a recipe for eventual disaster.  Start preparing your portfolio NOW, not when the bad weather appears.

As the old investing parable goes — You don’t start building the ark when the rain starts falling.

 

[Image Credit: Flickr1, Flickr2]

 

20 thoughts on “Will You Survive The Passive Investing Bubble?

  • September 11, 2019 at 2:19 PM
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    This is an interesting topic for sure. Mark from Our Next Life and I had several discussion on this so called passive investing bubble a few times during FinCon last week. We concluded that the bubble seems to be there because not everyone is investing passively. If everyone does invest in index funds, there wouldn’t be any bubbles. I think Burry does have a valid point and it will be interesting to see what the future holds.

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    • September 11, 2019 at 10:16 PM
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      If everyone does invest in index funds, there wouldn’t be any bubbles.
      This doesn’t make sense to me. If everyone keeps pumping money into index funds, the price will keep rising regardless of the earnings. That’s a bubble. The problem will come when everyone rushes to sell.
      Investors are underestimating what they can stomach.

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    • September 12, 2019 at 9:33 PM
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      Sorry to say this Tawcan, but I respectfully disagree with your conclusion. If everybody indexed there *absolutely* still could be a bubble. Why? Basic economics of supply and demand take over to determine prices.

      I actually theorize that over time we’ll see greater and greater volatility in the indexes as the percentage of passive indexers rises.

      Reply
  • September 11, 2019 at 2:45 PM
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    There’s definitely a bubble.. Because value investing has underperformed for 10+ years, even Buffett indirectly at the AGM has noted that value investing may not be the future since purchasing Amazon.
    That plus the fact the usd has appreciated against every global currency makes me feel theres more risk than upside to the s&p index.

    Either the trade wars or the weaponization of the US dollar triggers it, but I feel the bubble is getting a little scarier these days..

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    • September 11, 2019 at 2:58 PM
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      This is all said slightly tongue in cheek of course. No one knows if it is or isn’t going to happen and they definitely can’t forecast timing…

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      • September 11, 2019 at 4:53 PM
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        Very interesting to consider, especially as I invest for my child’s future too. I think it’s certainly a valid point.

        I’m prone to keeping more cash on hand than many, something that’s served me well through major family emergencies. Ok, maybe not straight cash, but a vanguard money market account.

        I hope the bubble is a long ways out as I’m not ready to learn all the ins and outs of investing yet!

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      • September 12, 2019 at 9:35 PM
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        Yep, nobody knows! This is exactly why I think people should pay more attention to how much they’re paying for index assets instead of “set and forget”.

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        • September 12, 2019 at 11:34 PM
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          Nothing good can come from always buying at a PE of 30+…

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  • September 11, 2019 at 3:28 PM
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    I’ve read about this before and like you said, it’s uncharted territory. While I understand the premise of his argument, I think markets are far too complex and large to make that simplistic of an argument hold water.

    But what do I know, I write satirical finance articles and sell t-shirts and coffee mugs 🙂

    Reply
    • September 12, 2019 at 9:37 PM
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      Hey, as long as you’re respectful I don’t mind a little disagreement! 😉

      P.S.: I want a “I survived the passive bubble” t-shirt! 🙂

      Reply
  • September 11, 2019 at 5:08 PM
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    Predicting is very hard, especially about the future, as the great Yogi Berra said. The fact is that the signal to me, basic as it is, is using the P/E ratio. When that goes above the historical average, then I see if it’s deserved or not. Its a simple model, but my opinion on complex models is low. I did modeling for radars when we had a physical one to compare against, and it was still extremely difficult to tune correctly. I find cruder models get tricked less at the cost of fidelity and usually length of predicted results. I will add that I have higher hopes for trained AI modeling. I have not done it but I have read a good bit about it. Its great for many things, but my take on financial modeling is politics. Can anyone guess or predict how our trade war will turn out, or who will win the next election?

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    • September 12, 2019 at 9:39 PM
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      I wouldn’t recommend using P/E’s alone. Interest rates should definitely be considered along with PE’s.

      So what happens when we get to negative interest rates and greater than 50% of all investors are passive indexers? In my mental simulations, crazy things happen that I don’t like to think about.

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  • September 11, 2019 at 7:20 PM
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    So pretty much, it’s not really that there’s a passive investing bubble, but rather that passive investing is exacerbating the existing and well known equities bubble, which will eventually pop as it’s done before? At which point, the market will correct or crash, as everyone’s predicting anyway, at which point the best thing for investors to do will be to invest even more?

    So I guess the lesson of his warning to allindex investors is “Keep doing what you’re doing”.

    Sincerely,
    ARB–Angry Retail Banker

    Reply
    • September 12, 2019 at 9:43 PM
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      You’re not wrong. The problem is if the market crashes and remains depressed for a couple decades most proponents of passive index would have long given up on dollar cost averaging.

      Imagine you paid $1000 a share for something in 2019. Then in 2020 a crash happens and those shares remain $1 for the next couple of decades. Most average investors would be pretty disgusted with the indexing strategy.

      Reply
  • September 12, 2019 at 5:10 AM
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    When a passive index fund goes up in price, it rewards the laggard companies, when it goes down, it punishes the good companies. So price distortion occurs on both the upside and downside. Ouch!

    What one might say, is consider the various “weights” of the given index or passive fund, that comprise its holdings. Another aspect is the liquidity of a given fund, very specialized funds with limited participation and/or low share turnover per day may have more exposure to a “bank run” on the fund.

    Reply
  • September 12, 2019 at 6:33 AM
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    I can certainly see the kind of bubble you’re talking about happening. However, there are a lot of people out there who let automatic withdrawal from their income go straight to their 401k and then it automatically purchases some type of index fund. These people never look at their portfolio except maybe once a year. I think it is this group that makes it really hard for the bubble to pop. This is also why I think index funds are great for a new investor, but not as good for a large portfolio. When you are starting out with a few hundred or a few thousand dollars, the rate of return is really not as big a deal. You don’t want a complete loss. The sheer amount of diversification in this index funds comes as close as you can get to guaranteeing you will not have a complete loss. It is also guaranteeing you are not going to hit it out of the ballpark. When your portfolio gets to the size of $50,000 or $100,000 or more, the rate of return does matter or the dividend payout may really matter depending on your investment goals. This is when I believe most investors should add some individual stocks to their mix.

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    • September 12, 2019 at 9:46 PM
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      I’m all for diversification, but yeah… until you get to a decent size net worth it’s not necessary to “be creative” in how you invest. 😉

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  • September 12, 2019 at 9:14 AM
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    The funny part about bubbles is that there are always good explanations as to why they are not bubbles until they crash. With tech stocks, it was that the valuation metrics of the past did not correspond to valuing a ‘dot-com’ stock. People were told to focus on ‘eyeballs’ and ‘stickiness’ and ‘scalability’. With housing, surely the lenders knew what they were doing! Maybe it will take time, but with houses increasing in value you’d be stupid not to leverage and get rich quick. And it might’ve worked if supply hadn’t increased, financial institutions created all those derivatives, and ratings agencies been so generous with investment grades… But this time, Index Investing will be different. Onward and upward forever I’m sure … unless inflation spikes and the Fed needs to limit QE and raise rates, or something bursts the borrowing bubble, or investors just decide to freak out…

    Reply
    • September 12, 2019 at 9:46 PM
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      Couldn’t have said it better EV2020! This time it’s different…. 😉

      Reply
  • September 17, 2019 at 4:32 PM
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    Globally, index funds only own around 10 per cent of the value of all investable securities. This figure includes around 15 per cent of traded equities and 5 per cent of fixed income securities. In other words, the indexing story has a long way to go and grow.

    Reply

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