Imagine there was a cookie market made up of two types of cookies, tasty and meh. An active investor in cookies would spend time determining which cookies are likely tasty and which are meh. They would pay more for the tastier cookies so they can savor the flavor and less for the meh ones they can binge eat in the shower when no one is home.... A passive investor comes along and says, I don't want to do all this research, I'll just assume the market was able to price these accordingly and buy any cookie at the market price. At the beginning, it is great. They just sit back and buy baskets of cookies, some tasty, some meh... but they always pay the higher price for tasty and lower price for meh, so it is fair. Over time, more people start buying baskets of cookies rather than spending time/money figuring out what to pay for them. At some point, no one is left to figure out which cookies are tasty vs meh, so the price of all cookies converge to a single price. Cookie manufactures notice this and figure might as well just make meh cookies as no one can tell the difference until after they buy them... and then we are stuck in a world with meh cookies. With some critical mass of active cookie investors, prices could be set fairly for all cookies. Too many active investors, and there is a drain on the system as there is likely a lot of duplicated work among the investors ( each one has to have a research team, back office cookie trading systems, etc, etc ). Too little and prices become less accurate.
"What if everyone became a passive investor" is like worrying "What if the entire ecology became defenseless herbivores?"
It just won't happen, because there's a negative feedback loop against it, leading to a kind of homeostasis.
> At some point, no one is left to figure out which cookies are tasty vs meh, so the price of all cookies converge to a single price.
Five minutes later someone says: "Holy shit, I can make a ton of money by buying loads of cookies, sorting them, and re-selling them -- except with the definitely-tasty ones at a higher price."
At the limit of 100% passive, everyone agrees the system would break down. But that’s not a realistic endpoint. There are studies to suggest that as little as 1% active is enough to keep the markets functioning and we’re nowhere near that point.
Of course at 1%, or really, any sufficiently small and centralized number, it becomes easier and easier to game the system...
I'm thinking specifically of attempts to artificially inflate crypto coin valuations for members, then quickly sell off before anyone catches on. Should be, I would think, impossible to do that across a large area of the market, but if everyone is investing in index funds, it might be, I would guess.
Nonetheless, for my situation, index funds are the best rational solution. That or hiding all my money under my mattress.
A merit of the passive approach is that the act of buying tasty cookies will increase the tasty-cookie price. The passive investors' existing tasty-cookie holdings will increase in value, too.
All the passive investors want is for their cookies (and new-cookie acquisitions) to be properly priced. No matter what, they have an average distribution of cookie-quality in their holdings.
The passive investors are not buying cookies at any price other than the market price. Whatever the clever-cookie-buyer is paying for cookies, they're paying the same. If a clever-cookie-buyer buys low, takes out an ad in Cookie Magazine, and sells high to a bunch of tasty-cookie aficionados, the passive investors win, too. If a too-clever-cookie buyer buys low and discovers that the apparently-tasty cookies have spoiled, the passive investors lose a little, too.
It is hard to bilk a passive investor. The first people to really figure out how will accumulate a lot of money (and ire).
> All the passive investors want is for their cookies (and new-cookie acquisitions) to be properly priced.
No, they want the cookies they purchase to be under-priced, and consumed once their price has gone up. The cookie analogy fails here, but passive investors are exclusively seeking return, not an efficient market.
> No matter what, they have an average distribution of cookie-quality in their holdings.
That's not how passive investing works. The classic model is investment in an index -- say the FTSE 100 -- which attempts instead to maximize the quality of holdings, not the most accurately priced.
> It is hard to bilk a passive investor
Yes, but that doesn't mean it's hard to make money off one.
In theory. In practice the people who can control market pricing can force out even passive investors because passive investors still get valuation reports albeit on a less timely basis. Burry almost lost his shirt shorting sub-prime credit, as Morganchase and Goldmans mispriced his derivatives more and more egregiously as the market moved in Burry’s favor in a bid to get his investors to force him out of his/their positions using ignorant fear. Passive investors are generally not market savvy, that’s why they are passive.
Yeah I think the consensus is that 100% passive would be terrible.
Jack Bogle's view was that if the market is 50%+ passive indexed that would be bad news.
Some folks argue that the number is even more extreme, that passive indexing generally increases efficiency, and that as long as there are even a handful of active investors, the market will still be efficient: http://www.philosophicaleconomics.com/2016/05/passive/
What i understood was all investors are buying basket of tasty cookies and no one is buying meh cookies' basket or cookies. So tasty cookies are overvalued and meh cookies are under valued.
The quality of the asset has nothing to do with this issue.
In both cases the actual buyer is an intermediary, who is managing many people's money. Those people don't even know or care what is being invested in. If for some reason many of them decide to disinvest around the same time (say a recession) they may be hurting themselves due to the asymmetrical nature of the action.
At that point, an active investor can say that any losses by holding the stock an additional month would be eclipsed by selling immediately. A passive investment does not have that ability.
"And now passive investing has removed price discovery from the [cookie] markets. The simple theses and the models that get people into [cookie baskets] -- these do not require the [cookie]-level analysis that is required for true price discovery."
I think the flaw in this analogy is that it's impossible to know beforehand whether the cookies are tasty or not. And a cookie that was previously tasty might not be tasty any more.
