Can the Stock Market Really Go Up Forever?

Summary

This video explores the rise of index funds, a passive investment strategy that has become dominant in modern markets. It explains how index funds work, their origins, and why many believe they offer the best long-term returns for average investors. The video also addresses concerns about potential overvaluation due to the growing popularity of passive investing and whether this could lead to market instability. Ultimately, it encourages viewers to understand the risks and rewards of investing in index funds, emphasizing the importance of being an informed investor.

Takeaways

• 📈 Index funds have become one of the most popular investment vehicles for Americans, surpassing actively managed funds.
• 📊 The rise of index funds is based on the efficient market hypothesis, which suggests that stock prices reflect all available information and it's impossible to consistently beat the market.
• 🤑 The main appeal of index funds is that they track the market as a whole, offering average returns without the need for active management, making them a simple way to invest.
• 💰 Index funds are typically cheaper than actively managed funds because they require less human oversight, which means lower fees and better returns for investors.
• 📉 Some analysts are concerned that the rapid inflow of money into passive funds might be inflating stock prices, potentially leading to market overvaluation and future corrections.
• 🤔 The inelastic market hypothesis suggests that for every $1 invested in the market, the value increases by $5, potentially accelerating market movements and increasing volatility.
• 🏦 Despite concerns, many financial advisors, including the speaker's high school economics teacher, continue to promote index funds as a smart long-term strategy for building wealth.
• 💼 The study of the inelastic market hypothesis challenges the efficient market hypothesis, suggesting that passive investments could have a larger impact on stock prices than previously believed.
• 🛠 Vanguard, a major player in the index fund space, defends passive investing, claiming that active managers still determine most of the stock prices, mitigating the potential dangers of passive overvaluation.
• 📉 Even with potential risks, index funds are still seen as a reliable way to diversify investments and reduce risk, especially for average investors looking for long-term growth.

Q & A

What is the primary investment vehicle discussed in the script?

The primary investment vehicle discussed is index funds, specifically funds that track large segments of the market, like the S&P 500.

What theory supports the idea behind index funds?

The theory supporting index funds is the Efficient Market Hypothesis, which suggests that stock prices reflect all available information, making it nearly impossible to consistently outperform the market.

What is the Efficient Market Hypothesis (EMH)?

The EMH proposes that stock prices reflect all known information, meaning prices are rarely far off from their true value, and no one can reliably predict market changes.

Why do some analysts worry about the rise of index funds?

Some analysts worry that the increasing investment in index funds may be overvaluing stocks, possibly leading to a market correction or increased volatility.

What is the difference between actively managed funds and index funds?

Actively managed funds involve a team of analysts making decisions on which stocks to buy or sell, often charging higher fees. In contrast, index funds simply follow a market index like the S&P 500, typically offering lower fees.

Who played a key role in creating the first index fund?

John C. Bogle, the founder of Vanguard, played a key role in creating the first index fund that tracked the S&P 500.

How did index funds gain popularity over time?

Index funds gained popularity due to their consistent performance over time and lower costs compared to actively managed funds. They also benefited from the rise of 401(k) auto-enrollment and companies like Fidelity enabling regular people to invest.

What does the inelastic market hypothesis suggest?

The inelastic market hypothesis suggests that for every dollar invested into the stock market, the market’s overall value increases by five dollars, indicating that the market might be moving much faster than previously thought.

What are the potential risks of index funds according to critics?

Critics argue that index funds could be overvaluing large companies and that passive investors might distort stock pricing, leading to increased market volatility and potential overvaluation.

Why do many people still advocate for investing in index funds?

Many people advocate for index funds because they offer a simple, low-cost way to match the overall market performance, distributing risk across a broad range of stocks and historically providing good returns.

Outlines

00:00

📈 The Rise of Passive Investing

The first paragraph explores the growing trend of passive investing, particularly through index funds. Various sources, including articles, influencers, and personal finance figures, suggest that investing in index funds is a simple and reliable strategy for wealth building. However, the narrative reveals potential risks as more money flows into these funds, and some analysts worry that this could lead to an overvaluation of stocks and market instability.

05:01

📊 The Birth of Index Funds

This paragraph dives into the history of index funds, beginning with Paul Samuelson's call for a fund that tracks the S&P 500. John C. Bogle, the founder of Vanguard, made this vision a reality by creating the first index fund. Despite early skepticism and attempts by fund managers to undermine its success, index funds have gained popularity over time. The logic behind index funds, driven by their cost-effectiveness and simplicity, has led to their dominance in the investing world.

10:01

📉 The Inelastic Market Hypothesis and Potential Risks

This paragraph introduces a potential problem with index funds—the 'inelastic market hypothesis.' Researchers like Xavier Gabaix argue that the sheer volume of money flowing into passive funds could inflate stock prices faster than previously thought. Each dollar invested in the market could increase its value disproportionately. This could lead to market overvaluation and heightened risk of a rapid decline if investors lose confidence, raising concerns about future market stability.

Keywords

💡Index Funds

An index fund is a type of investment fund that aims to replicate the performance of a specific stock market index, like the S&P 500. In the video, index funds are presented as a passive investment strategy that has gained immense popularity due to its simplicity and effectiveness. The script explains how index funds allow investors to own a diversified portfolio with minimal effort and lower fees compared to actively managed funds.

💡Efficient Market Hypothesis

The Efficient Market Hypothesis (EMH) is the theory that stock prices always reflect all available information, making it impossible to consistently outperform the market. The video explains how this hypothesis supports the rationale behind index funds, as it suggests that no one can reliably 'beat' the market due to the constant adjustment of stock prices based on new information.

💡S&P 500

The S&P 500 is a stock market index that tracks the performance of 500 of the largest publicly traded companies in the United States. In the video, it is used as the benchmark that index funds aim to replicate. The growth and success of the S&P 500 over time are central to the argument for why index funds tend to outperform actively managed portfolios.

💡Passive Investing

Passive investing refers to a strategy where investors buy into funds like index funds that track the market, without actively selecting individual stocks. The video explores the rise of passive investing as a popular and cost-effective way to invest in the stock market, while also discussing concerns about its potential impact on market stability.

💡John C. Bogle

John C. Bogle is the founder of Vanguard and the creator of the first index fund. In the video, Bogle is credited with pioneering the idea that passive investing through index funds is the best strategy for average investors. His philosophy of 'you get what you don’t pay for' highlights how low fees associated with index funds contribute to better long-term returns for investors.

💡Inelastic Market Hypothesis

The Inelastic Market Hypothesis suggests that the stock market reacts more dramatically to investment flows than previously thought, with each dollar invested inflating the market value disproportionately. The video introduces this theory to challenge the Efficient Market Hypothesis, raising concerns that the growing popularity of index funds may be driving overvaluation in the market.

💡Market Correction

A market correction refers to a significant decline in stock prices, often following a period of rapid growth or overvaluation. The video discusses how some analysts fear that the influx of money into index funds could lead to a market correction, as stocks may become overvalued due to passive investment strategies that don't consider individual company performance.

💡Actively Managed Funds

Actively managed funds are investment funds where portfolio managers make decisions about which stocks to buy or sell in an attempt to outperform the market. The video contrasts these funds with index funds, noting that most actively managed funds underperform compared to passive strategies like the S&P 500, while charging higher fees.

💡Fees

Fees refer to the costs investors pay to participate in investment funds. The video highlights how index funds typically charge lower fees compared to actively managed funds, which is one reason why index funds tend to deliver better long-term returns. The lower fees of index funds, often as low as 0.2% to 0.5%, are a major selling point in their favor.

💡401K Auto Enrollment

401K auto enrollment is a feature where employees are automatically enrolled in their company’s retirement savings plan, often investing in index funds. The video explains how this practice has helped drive the massive growth in stock market participation among Americans, with trillions of dollars now sitting in index funds through retirement accounts.

Highlights

Passive investing in index funds has gained popularity, with trillions of dollars funneled into these investment vehicles.

The efficient market hypothesis suggests that stock prices reflect all available information, making it hard to consistently beat the market.

Index funds aim to track the overall market performance by investing in a broad set of companies, like those in the S&P 500.

John C. Bogle, the founder of Vanguard, pioneered the first index fund in 1974, allowing people to invest in the S&P 500.

While index funds have grown in popularity, concerns have emerged that passive investing could inflate stock prices and overvalue companies.

The inelastic market hypothesis suggests that for every $1 invested in the stock market, it could increase the market’s value by $5, raising concerns about potential overvaluation.

Index funds are less expensive to invest in compared to actively managed funds because they require fewer resources to maintain.

Despite their popularity, some worry that index funds are contributing to market bubbles by systematically funneling money into large-cap companies.

Vanguard’s analysis found that 95% of stock trading is done by active managers, suggesting index funds have a minimal impact on stock prices.

Concerns persist that the market could be overvalued, and a sudden shift in sentiment could lead to a rapid downturn in stock prices.

The rise of index funds was fueled in part by 401(k) auto-enrollments and increased access to investment platforms like Fidelity.

Despite skepticism, index funds remain a dominant strategy for long-term wealth building, favored for their simplicity and cost-effectiveness.

Active fund managers have struggled to consistently outperform the S&P 500 over time, with 89% underperforming in the last 15 years.

Index funds offer a way to diversify investments and reduce risk, as they allow investors to hold shares in a wide range of companies.

The stock market’s future performance is uncertain, and while index funds have been successful, they are not guaranteed to continue providing high returns forever.

Transcripts

If you've ever thought about investing your money,

you've probably heard this

one piece of advice on where to put it.

"I'll be very simple.

Under the conditions you name, I’d

probably have it all in a very—."

Articles, books, influencers, and my

high school econ teacher

have increasingly promoted

this special place to put your money.

"Definitely don't do *

investing and just be willing to *."

"Statistically, this is the simplest way

to build wealth for probably 99% of investors."

And slowly, American workers have funneled

trillions of dollars

into this investment vehicle.

But, its success

is built on a 50 year old theory

of how the world works.

And that theory might be off

by a factor of 500.

For the first time ever, funds

that simply track large swaths of the market,

like the stocks in the S&P

500, now have more money invested in them

than actively managed portfolios.

But as money continues to funnel in,

some analysts are getting worried.

People joining passive funds

might be overvaluing stocks and could be leading

the market towards a massive correction.

So should we keep going this direction?

Let me step back for a second.

The reason I got into this story

was because of this chart,

which isn't that different

from this one or this one.

These are graphs

to track the overall growth of the stock market.

And they're going up very fast,

almost too fast.

And I'm invested in the stock market.

So obviously I want the stocks to go up.

But I'm also skeptical.

Why is this happening.

This is the story of "index,

index, index, index,

index funds"

how they slowly gobbled up

the stock market

and might be based

on a giant lie.

50 years ago, index

funds didn't exist, but slowly

they've gained their evangelists.

One of the first people to pump index funds to me

was my high school economics teacher.

So I'm going to talk to him about

why he thinks they're good.

"Hello" "There he is."

What's up man. Good to see you.

Thank you again for meeting with me.

Hey, it's my pleasure.

It's awesome.

So I wanted to just ask you the biggest question.

Why do you think index funds are a good investment?

Well, there's an awful

lot of volatility in the market.

So the idea for an index fund comes

from this long debate about what actually

makes the stock market go up and down.

As long as the market has existed,

there have been countless theories trying to answer

that one question, because if you can figure that out,

you can make a ton of money.

And in the 1960s, economists popularized

a theory called the efficient

market hypothesis

that became a foundational

belief behind modern investing.

Could you start by describing

what the efficient market hypothesis is?

A giant lie.

All right, that wasn't helpful for you.

Sorry.

The efficient market hypothesis

just means that the current price reflects

as much information

as could be obtained

in a economically efficient manner,

and therefore prices

are rarely wrong by all

that much. Explained another way,

the efficient market hypothesis.

It's like bidding on something you can't entirely

see. Hey bidder bidder

Today we're auctioning off whatever's

inside of this box.

Hey, bidder

bidder, that's a tail.

Oh, I've seen this before.

It's got to be an elephant.

$500.

That good with you?

Sold for $500.

We've got 24

million more of these folks

for the right price.

20 more sold for $500. $499!

Oh, we've got an update.

The object in the box

seems to have a bidder, bidder

leaf on it.

Uh oh, sounds like a tree to me.

$300. $500 $475

$400

Oh, fine.

Sold for $300,

$300, $300 a sold $300.

Sold $301. Sold.

As you can

see, the price of the box, stock was immediately

updated to whatever new information came out.

It's basically impossible

to predict what would happen next.

Oh hey, new information

that feels like gold to me

$600 $900 $1,000 sold.

So if this hypothesis is true,

no one, neither Warren

Buffett nor you and I can reliably beat

the market because doing

so would require predicting the future.

But if every stock is

updated with new information,

the most efficient way to invest

would be simply to buy

the market as a whole.

And that doesn't guarantee the value will go up.

But if it does,

which it has historically, then

you'll get as good of a return as anyone.

But how do you follow the market?

The most popular way to track the stock

market is through an index

like the S&P 500, which takes the stocks

from 500 of the largest US companies,

weighs them by their market cap,

then combines them into one number.

If the number goes up, those 500 companies

stocks are also generally going up.

If it goes down,

they're generally going down.

So in the early 1970s,

people tested this theory and compared

their individual returns

to the S&P 500.

They found that over time,

the S&P basically always wins out.

But there wasn't an easy way

to actually invest in the S&P

500 itself.

So in 1974, after the idea

had been floating around for a while,

this guy named Paul Samuelson writes

in the Journal of Portfolio Management

that someone should just make a portfolio

that tracks S&P 500.

So the idea is essentially to ride in the backs

of all the investors actively working

to figure out where to put their money

and just putting in the same places.

And by chance, this other guy named John C

Bogle, who just started

a new mutual fund called Vanguard,

read this article and thought it was a great idea.

So he makes one

by buying all of the companies

in the S&P 500 in the same proportion.

Vanguard makes a single fund

that gets the same returns

as the S&P 500.

And now you, an individual person,

can buy a piece of that fund

and take that portion of the returns,

the first index fund.

Bogle thinks

this is the next big thing,

but others don't.

In 1976, the fund IPO's,

with the goal of $150

million investment

and gets $11 million.

Meanwhile, opposing fund managers

who get money through fees

try to kill indexes before they take any of

their clients.

One famous poster made by an investment

group read "index funds

are unAmerican",

arguing against the conformity

of just thoughtlessly following everyone else.

But over time, the logic of index funds wins out.

According to a 2020

analysis, 89% of all

domestic funds underperform the S&P 500

in the last 15 years.

"There's no 20 year

period of time where the S&P

500 has gone down right.

So over that long

period of time, yeah, it's kind of true.

Like the market does only go up."

Sometimes people do better.

But over time because it's so hard

if not impossible to predict the market,

the likeliest success

is the average.

I can't believe

how much money I have

and my starting salary

in 1992 was $13,900.

And I'm, you know,

probably going to retire

with a few million dollars.

That's just it

blows my mind away.

And buying an index fund can be even cheaper

than an actively managed fund

that has the same exact stocks.

Because there's not a team of analysts,

you're paying to decide what stocks to include.

That's allowed companies like Vanguard to charge

very low fees to buy into their funds.

Across the market, index funds

tend to charge between 0.2 and 0.5%

of the cost of the fund to invest. While actively

managed funds charge upwards

of 12 times more,

with rates between

1.3 and 2.5%.

So in a sense, you can beat the market

with an index fund because, as John

C Bogle would say, you

get what you don't pay for.

So while many people pay

big fees to get market results,

people invest in index funds, pay

smaller fees and thus

get more of the returns.

From 1980 to 2023, the percentage of Americans

holding stocks went from 13% to 61%,

which was fueled by the rise

of 401K auto enrollment and companies

like Fidelity that enabled

regular people to invest.

And now tens of trillions of dollars

are sitting in index funds,

reaping the rewards of a great strategy.

But not everyone thinks so.

If we believe the efficient

market hypothesis, the answer has to be that

this line is just what

things are worth.

And we'd also assume that

the giant fluctuations are simply due

to tons of people individually making

tiny little adjustments based on their own analysis.

Generally, economists assume

a marginal $1 invested into the market

had nearly no impact,

perhaps a cent,

but a study from 2021

challenges this notion.

This is one of the guys who wrote it.

My name is Xavier Gabaix

I'm French, so I'm

a professor of economics at,

Harvard University.

In this study, he and his coauthor identify

a system distinct from the efficient market.

Most investors

just stay on the sidelines.

We don't participate.

Or if we do participate in a very, very- not

particularly thoughtful

and attentive way.

This is a big realization.

The auction scenario assumes that the bidders actually

care about what's in the box

and how much it's worth.

But the way a lot of

nonprofessional investors invest

today doesn't really make a difference.

Hey. What's up?

Just got my paycheck.

How much for one? Share?

$500.

Sweet.

Cash it. It's payday.

Deal me in too. $600.

Works for me.

One more for me.

I feel bidder bidder bad,

but $800? Great.

That means I can get two.

Through the rising popularity of index funds

and other passive investment vehicles.

More and more people are simply piling money

into the stock market regardless

of how much a stock is really worth.

And according to Xavier and his coauthor Ralph

Koijen inelastic market

hypothesis, this money

coming in is inflating prices

much faster than previously believed.

The surprise is how big the effect is.

The stock market is this like this bizzare machine,

where you invest $100 in the machine

and the machine is worth

$500 more.

And of course, it's symmetric for buys and sells.

So for every $1 that goes into the market,

the overall value of the market goes up $5.

And for every $1 that goes out of the market,

the overall value goes down $5.

It's a hypothesis because

it's not a proven theory.

But if it's true,

this could mean that the market is moving

at least 500 times

as fast as we previously thought.

Under the efficient market hypothesis.

So what are the consequences of that?

Well, this means that the market

could be overvalued.

And if enough people come to believe that

that's the case, investors will sell their shares,

which would send the prices of stocks down

and cut the value of the investments

many people have in the market.

And given what the inelastic market

hypothesis says about how the market works,

this process could happen

very fast.

Beyond volatility.

Others worry

index funds are overvaluing the largest companies

as they systematically inject money into them

and with huge amounts of money

under their management.

Some, including the founder

of Vanguard Rest in Peace, worry

that companies like it are becoming too large,

and a significant portion of some company

stocks are owned by index funds.

But to push back on this charge,

most people don't think indexes are a problem,

at least not yet.

In response to fears that passive investors

are somewhat mindlessly paying whatever

the market asks, a representative

from Vanguard says passive investors

have a tiny impact

on how stocks are valued.

A report by Vanguard found that

at least 95% of the stocks

bought and sold in a day

are by active managers,

suggesting prices are mostly determined

by people who are well informed.

So that would change the auction

scenario to be more like this.

Hey what's up?

Just got my paycheck.

How much for one share?

Based on our analysis,

we believe the value is

$312.42.

Cash it.

If this is true, there's a lot less to worry about.

But Mike Green would urge us to not downplay

the impact of quote unquote,

passive investors, even though

they're supposedly just following the market.

They are still buying

and selling, which affects the pricing of stocks.

If you actually believe

in the theory of passive, you have to accept that

it is distortionary

for you to decide

to do anything in the market.

Still, if you ask a lot of investors,

they'll scoff at these worries.

My econ teacher is still pumping indexes.

I tell young people, and I teach this

in my personal finance program.

Start early, save every month,

don't touch that money and just put your money

into a stock

index mutual fund.

Always works.

When I ask a certified financial planner

if he knows any doubts about index funds, he said,

People have doubts about

index funds?

That's interesting.

I don't know, too many like people like know

like you gotta go, gotta go

active management.

This is the only way to go.

Trying to give you an answer

on that one, I don't think I have one.

And Xavier still thinks index funds

is the best move for the average investor.

The guy in charge of all of

Vanguard's equity index trading was a bit

more tempered, and said past performance

is not indicative of future performance,

but most angles still support indexes.

Returns continue to increase.

American businesses have expansive global impact,

and people seem bullish on their investments.

And even if the stock market

does end up going down,

many would argue

indexes are still the best way to distribute your risk

at the end of the day, the stock

market is a lot of things.

It's a marker of companies and their practices.

It's a measure of hope for a better future,

and it's a function of people's

fundamental fears.

And as long as the assumptions

driving the market continue to lead the stock market up

a hill, investing in

index funds might still be the best move.

After all, if the market moves up

and you're not invested, you'll miss out on money.

So are you dancing

while the music is playing?

Unfortunately, you have to write,

but eventually the music might stop

or get quieter.

So there's an argument

to reducing your risk.

The market doesn't exist for retirement.

The market exists to facilitate the addition

of capital at an appropriate marginal cost.

And so when we break those

systems, I don't think we should be

the least bit surprised

that capitalism itself

is threatening to break.

Ultimately, I'm not saying the stock

market's going up or going down,

but I hope this video leaves

you with one insight.

50 years ago, a guy

made a fund that couldn't be beat,

since this simple idea has taken a hold

among many investors,

and for many it's worked.

But the stock market is not guaranteed

to do anything as much as we can

break it down and average it.

There's nothing ensuring

that the stock market will go up forever

other than through the faith of investors.

So if you're investing

all I hope for you is that you understand why.

Maybe it's because someone told you to.

Maybe it's because you believe in the masses.

But even if you're

investing passively,

be a little bit

less passive of a passive

investor.

Toto, Toto Toto Toto Toto

Toto man,

it's really gets my voice going.

No! Lose it.