Arnold Kling  

Comment of the Week, 2003-04-02

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The Budget Debate, VIII... Surveys Vs. Revealed Preferenc...

On the issue of index investing, Yasser Mawji wrote


Surely there's a problem of aggregation that's inherent to index fund investing. If most investors are blindly purchasing index funds without any regard for valuation, then those stocks which constitute the index will become overvalued.

Back in 1999-2000, a stock would rocket 20% or more on the announcement that it was being added to the S&P 500, because investors anticipated large-scale buying from index funds who would soon be forced to buy the stock. So, stocks that were added to the index fund tended to be very overvalued. To make matters worse, the S&P favors stocks with the largest market caps -- which also skews the index towards overvalued issues (assuming, of course, the market isn't perfectly efficient to begin with).

It was no surprise, then, that when the S&P 500 began it's precipitous decline a few years ago, the losses were concentrated in the index, as opposed to the broad market. In fact, the advance-decline line for the broad market was flat or rising for a long time.

For these reasons, index fund investing isn't a terribly good strategy, IMO.


(For those of you new to Internet-speak, IMO is short for "in my opinion").

Economists favor index investing. However, they understand that if everyone becomes an index investor, then markets would cease to be efficient. When someone brings up this issue, most of the time we wave our hands and say, "Well, enough people have to vary the weights of individual stocks in their portfolios to keep prices efficient." Other economists have developed more elaborate models, such as those that include "news traders" and "noise traders," mentioned by another commenter.

To continue the discussion, go to the original thread.


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