Confessions of an Index Investing Skeptic — Part III: The Great Grey Menace

When I was young I thought that money was the most important thing in life; now that I am old I know that it is.
— Oscar Wilde

The first Baby Boomer turned 65 in 2011. This generation has a number of qualities that make this an event that is likely to change the market landscape dramatically.

A few items to note:

In short, Boomers find themselves faced with a much longer retirement, and many won’t have the resources to fund it. No matter which way you slice it, this is worrisome news for younger workers. Boomers faced with outliving their savings will either have to work past the traditional retirement age, which will increase the supply of labor, driving unemployment up and wages down, or they’ll have to rely on public assistance.

Let’s set the gloom-and-doom scenarios aside for the moment, however, and focus on just one aspect — namely the shift to defined-contribution plans, and the resulting greater concentration of wealth in the stock market, which is unprecedented in history.

When a sizable chunk of a person’s net worth is tied up in the stock market, and that person retires and begins living off their nest egg, what happens? Unless they can live off dividends alone, the answer of course is they begin selling.

The retiree may be invested in index funds, actively managed mutual funds, or even individual stocks. It hardly matters. In all cases, they will gradually liquidate their holdings, not because a stock’s price had been bid up too high, or a product flopped, or a key member of management retired, or any other factor that might bear some relevance to the company’s value. No, the retiree will sell because they need to buy groceries. Yet those sales will move the prices of those assets every bit as much as the sales of a person who acted based on fundamental analysis.

Some worry-warts have suggested that this will lead to a massive stock market crash. I don’t think that’s likely, personally.1 However, at the risk of beating a dead horse, it does add still more to the massive wave of trades that are based on absolutely no information about the intrinsic value of the assets whatsoever.

It’s Not Just About the Boomers

From 1980 through 2008, the percentage of private sector workers with defined-benefit pension plans declined from 38% to 20%. This trend toward 401(k) plans serving as the primary basis of people’s retirement shows no signs of abating. If anything, it’s accelerating. If it continues apace, by the time Generation X’ers like me retire, it will be near ubiquitous in the private sector, and the public sector is beginning to move in that direction as well.

The debate is fierce as to whether defined benefit pensions or defined contribution plans are superior. I offer no opinion one way or the other — I see good points and bad points with both. The trend away from traditional pensions is clear, however, and the inevitable result is ever more trades that are not driven by judgments of valuation, distorting asset prices still further.

Welcome to the new normal.

  1. If it did happen, it would be a fantastic buying opportunity, since such a crash would have virtually no connection to any change in the true value of all those assets.


  1. If you were investing in index funds yourself Sean, but you COULD easily live off the dividends…. would all these factors still concern you?

    • Sean Owen

      That’s a real good question. Certainly much less so.

      By the way, I do invest in index funds in my 401(k). I don’t dispute that they’re a much better deal than actively-managed mutual funds.

  2. Artis

    Ok, please explain the following:

    “This is the state of industry in 2012: The most profitable fund in the world underperformed a simple S&P index fund. This year, Reuters reports, the average hedge fund returned just 3.17%. The Economist notes that a “simple-minded investment portfolio” — 60% stocks and the rest in sovereign bonds — would have returned 90% over the last 10 years.”

    • Sean Owen

      I’ve never claimed that actively managed mutual funds are a good alternative to index funds. Let me state it once again, and a bit more clearly: If your only choice is between actively managed mutual funds and index funds (typical for 401(k)’s, for example), the index funds are highly likely to be the better choice. My personal 401(k) consists entirely of index funds and a REIT ETF.

      Mutual funds have all kinds of limitations that individual investors don’t. They have Byzantine regulatory requirements controlling their trades. They have to allocate massive, market-moving amounts of money. They have to deal with investors buying in and pulling money out on a more or less constant basis. All this adds up to them having to spread their money between so many different stocks that they might as well be an index fund, only with much higher expenses. It’s no surprise that the “pros” can’t beat the market.

      Hedge funds have somewhat more lax regulatory requirements, but still face many similar issues.

      You, as an individual, don’t have these problems. Warren Buffett has famously said that he could easily make returns of over 50% per year if he had less than a million dollars to manage:

  3. Hmm, I seem to be starting a series of replies to your posts 🙂

    I love it when stock prices fall. My only reason for buying stocks is to get some share of the future profits from the underlying business. I assume those profits are fairly stable and generally increasing over time. If the price falls I can buy a bigger share of those profits, I can get more dividends, and I can re-invest those dividends at the same low prices to get even more. It’s a virtuous cycle of profits that only builds up the longer the prices stay down.

    We can’t say that the market has always been devoid of people buying and selling for personal reasons. Even Defined Benefit plans would have had to do some of this since they probably used more than just bonds. Unfortunately the aging population may not lead to a fall in the market.

    What seems to be happening now is a lot of capital chasing yield. Ironically this is causing people to buy into the stock market when they should not be doing that. The point of investing is to get income and then sell at some future time, so we shouldn’t be surprised that people do. I’m more concerned that increasing demand for investment income will mean people accept lower returns. This would mean rising stock prices initially.

    I monitor the indexes that I invest in to see if they are still attractive. As long as there is something somewhere that provides decent returns I will be a happy investor. And the real source of those returns is increasing demand for capital and potential for economic expansion (which increases the rewards from investment and the demand for capital). If the boomers start spending all their invested cash and building lots of golf courses we may see that happening, and not a moment too soon.

    You might say that index investing is not the best tool for the majority of people to manage their finances. If not, how can most people do better? Half of the active investors have to lose. If they just sit on cash they won’t go very far (and this is a particularly bad time for that too). The best we can hope for is that we clear out all the silliness in the markets quickly and allow reasonable investors to go back to making a reasonable return.

  4. Thomas Dudley

    Your note assumes that the price wasn’t overstated to begin with due to the factors mentioned in your post. I think this gets back to the difficulty surrounding the notion of “true value” on the stock market.

  5. Tony

    Hi Sean:
    I do like your contrarian approach to the accepted wisdom of indexing – if for no other reason then to get me thinking about my indexing strategy. We need more people like you challenging ideas! Devil’s advocate can sometimes be a lonely, thankless task … so thank you.

    One point – if the ‘boomers’ sell you argue the stock price will fall. But central to another part of your argument is the fact that more and more people are now buying stocks through 401ks etc. This would suggest the me that – as long as new entrants to that market out-buy the sellers – the boomer effect will not result in net outflows of cash from the system.

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