Can the Stock Market Really Go Up Forever?
Summary
TLDRThis 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
📈 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.
📊 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.
📉 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.
Mindmap
Keywords
💡Index Funds
💡Efficient Market Hypothesis
💡S&P 500
💡Passive Investing
💡John C. Bogle
💡Inelastic Market Hypothesis
💡Market Correction
💡Actively Managed Funds
💡Fees
💡401K Auto Enrollment
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.
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