In many of my postings on this website (including the post at the link below where I explain my overall investment strategy), I have discussed the numerous benefits involved with investing in index mutual funds.
For the most part, these benefits stem from the fact that the stock and bond markets are so efficient in the way they trade, that it is impossible to expect that you can beat the market.
However, what exactly causes these markets to trade so efficiently?
Even though there are several factors involved in answering this, one of the biggest contributors is the fact that there are so many investment professionals that spend all day performing research so that they can actively trade individual stocks or actively build mutual fund portfolios that will gain them superior returns. This phenomena causes price adjustments to occur very rapidly when new information becomes available.
In a way, it can be said that the reason that index mutual fund investing works so well is because so many people participate in active investing.
So, an interesting question then becomes, “What would happen if everyone invested in index mutual funds?” Answering this question will be the principle aim of this posting.
Larry Swedroe in his book,The Only Guide to a Winning Investment Strategy You’ll Ever Need provides, in my mind, a very good investigation of this question.
First, he states that there will always be some level of active trading due to 1) exercising of stock options, estates, mergers and acquisitions, and 2) companies buying stocks in other companies.
Second, he takes a look at what would happen if all money managers and individuals decided to buy shares in index mutual funds, and if index funds would still be the superior investment choice. His investigation is summarized below:
• In theory, it could be stated that fewer people participating in active investing would create a less efficient market due to the decreased amount of information being discovered about particular events/stocks.
o However, it is also likely that the only individuals/money managers that would continue to use active investing would be the ones that are successful at it. This would then indicate that the competition was even tougher than it is now, causing markets to revert back to being efficient.
• Since fewer people would be participating in active trading, this would result in less liquidity in individual stocks
• Additionally, trading costs would be driven upwards since fewer people are buying and selling.
As you can see by this investigation, while it is an interesting question to think about what would happen if everyone participated in index investing, it is 1) highly unlikely to happen, and 2) would still not cause active investing to produce superior returns.
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