Are index funds pyramid schemes?

[Zaphod]

Dusn wrote:

It does seem to me that index funds and the market in general seem to operate, to a certain extent, like a ponzi scheme.  I have to rely on future people to buy the stock at a higher price for my money in the market to grow.   Dividends from companies make up a small percentage of my earnings from the stocks.

And other people have already made the point that index funds do need some people to actively invest and to do it well.

I’d be happy to hear arguments about why this is not the case.

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A ponzi is a bit different than a pyramid scheme. Part of the push back was the pyramid comparison which isnt very good. We are not relying on personally recruiting others per se.

Yes, it does rely on certain future factors, not so much that people will be willing to pay more (a part) but that is implicit in that the economy grows to support todays valuations and changes into the future on a time frame that overlaps with your investing career. This is why demographics is so important. Profits and cash flows have to keep up, if they do, prices will justifiably rise.

[Dusn]

It does seem to me that index funds and the market in general seem to operate, to a certain extent, like a ponzi scheme.  I have to rely on future people to buy the stock at a higher price for my money in the market to grow.   Dividends from companies make up a small percentage of my earnings from the stocks.

And other people have already made the point that index funds do need some people to actively invest and to do it well.

I'd be happy to hear arguments about why this is not the case.

[Craigy]

Obviously the answer to the original question is no.  But I think it's an interesting mental exercise.

 

Just taking some things from the pyramid scheme wiki  https://en.wikipedia.org/wiki/Pyramid_scheme , things that also apply to traditional, long-term market investing:

• Encourages a large initial investment and continual reinvestments
  
  
  
  • Yeah we're supposed to buy, buy, buy.  Indefinitely, with every paycheck.  And never cash out.
  
  
  • And everyone else is supposed to do that, too.
  
  
  • Ok, maybe you can have just a few pennies back in retirement, but you should do that real slow over a lot of time. 
  
  
  • If you don't think your retirement portfolio depends on the rest of the public buying into the market (and largely holding their investments), you don't understand economics. 
  
  
  
  


• Promises large earnings with little effort
  
  
  
  • *All you have to do* is put money into the market and it will work for you.  Just look at this chart!  At 6% a year, over the course of your career, just by putting money in the account, you will have millions. 
  
  
  
  


• Poor or non-existent training
  
  
  
  • Most individual investors have essentially zero economic sophistication.  Even many of us on this forum.
  
  
  • ************************, these days, you can be automatically enrolled in a retirement plan without ever saying yes.  Same goes for any person with a pension or other guaranteed retirement benefit plan.
  
  
  • Even if you went to business school, virtually every investor is self-taught.  Which of course means that most investors haven't learned anything.  There are countless superficial articles, books, videos, etc out there to "educate" investors, but very, very few actually have a grasp on the economic or financial concepts upon which our market runs.
  
  
  
  


• No obvious product
  
  
  
  • Ok this is a tough one, since obviously the companies themselves make a product.
  
  
  • But you never/almost never directly give the company any of your own money.  You're just buying shares from a third party, and watching it grow.
  
  
  • Many of these companies don't even produce a dividend, so in many growth funds you're just buying shares for the speculative appreciation.
  
  
  • Your portfolio is not a business, it's a glorified bank account, a ledger of the money you've spent and an approximation of what you could get if you (but not everyone else) cashed out today.
  
  
  
  


• Often aggressive in its approach and may use deadlines to urge people to join quickly
  
  
  
  • Buy now; buy always and often; don't try to time the market, get in the market today; the market is about to take off, you need to buy in or you'll miss out; you are an idiot if you try to time the market; if you cash out, when will you know to buy back in-- it will be too late.  
  
  
  
  


• Inability to out-earn anyone above
  
  
  
  • There is always a bigger fish.  While we earn thousands, hundreds of thousands, or even millions on our portfolios, the real market players and benefactors are the execs, the board members, the founders, the banks.  We buy the stocks, our pensions buy the stocks whether we want to or not, we buy the products, they get the multimillion dollar bonuses, the billion dollar breaks and the huge golden parachutes even if they fail.
  
  
  
  

 

At first I was going to just take a few of the easy ones, but you can make an argument for each.  Admittedly some of these arguments are more or less compelling, and obviously you can pick that all apart, but the biggest difference *on the surface* is that a pyramid is typically aimed at the shorter-term while market investing is long-term (though companies like amway, mary kay, and many hundreds more are certainly long-term frauds).

[Hatton]

I have a mixture of active funds, indexes, and individual stocks.  I too worry that too many people are indexing.  It is the right thing to do until it is not.

[pulmdoc]

Human nature being what it is, I'll take my chances betting with Vagabond that the market will never be 100% indexing. People are greedy and think they can find alpha. Some of them will even be right! Not to mention large chunks of stock will be owned by individuals/owners of these companies.

[juststarting]

My kids looooove this song from Teen Titans Go:  "Making my money, the pyramid scheme money..."

https://www.youtube.com/watch?v=RvgYOIHtWDA

[Zaphod]

Perry Ict wrote:

Jaqen Haghar, MD wrote:

Not a pyramid scheme, but I do sometimes wonder what (yet unforeseen) problem/crash will arise over time, as more and more people use an indexing strategy.

When people ask about the problems with passive investing through indexes, they get shut down pretty hard and responses get emotional quick.  (To me, not a great sign)

Most opponents against passive index investing have a vested interest in getting commissions from active investing, so info against it is often biased, and good info is scarce.

Still, when everyone piles into something, and fails to consider the downside risk, it can sometimes set up a future surprise disaster.

…But I still use mostly a passive investing strategy.

for now.

 

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Well said.  And what you said in bold worries me too.

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People are free to read deeper dives into it, like say at Philosophical Economics. Its extremely long form and in depth but go for it. There just isnt a necessarily large amount of discretionary trading required to set prices, and of course the big kicker is that humans are always going to be greedy and tons of indexing only opens up a new set of possibilities to make money and people will chase those.

Also fails to recognize that most is already indexed, the shift that is getting complained about isnt stock pickers to indexing, its the movement from high cost indexes to low cost ones. You can guess where the whining is coming from.

[Perry Ict]

Gotcha.  Probably true.

[VagabondMD]

Perry Ict wrote:

Vagabond MD wrote:

runfast00 wrote:

Exactly, better said than me.  If everyone is only indexing will it over value the stocks in the index. 

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In theory, it could amplify the market highs and deepen the market lows. The good news, is that not only are we not even close to that situation, it will never happen.

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What is it that you’re saying can’t happen? Another major market crash?

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What I am saying is 100% of stock investing will never be in indexes. That is all.

[VagabondMD]

Perry Ict wrote:

Jaqen Haghar, MD wrote:

Not a pyramid scheme, but I do sometimes wonder what (yet unforeseen) problem/crash will arise over time, as more and more people use an indexing strategy.

When people ask about the problems with passive investing through indexes, they get shut down pretty hard and responses get emotional quick.  (To me, not a great sign)

Most opponents against passive index investing have a vested interest in getting commissions from active investing, so info against it is often biased, and good info is scarce.

Still, when everyone piles into something, and fails to consider the downside risk, it can sometimes set up a future surprise disaster.

…But I still use mostly a passive investing strategy.

for now.

 

Click to expand…

Well said.  And what you said in bold worries me too.

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There is a strong Boglehead-flavor indexing influence here, and it gets handed down by them man (the @WCI) himself, but plenty of us are engaged in non-indexing investment activities for various reasons. Mostly, we never talk about them here. There is quite a bit more to the investing world than the Bogleheads, which is largely an echo chamber (and a very beneficial one at that).

[Perry Ict]

Vagabond MD wrote:

runfast00 wrote:

Exactly, better said than me.  If everyone is only indexing will it over value the stocks in the index. 

Click to expand…

In theory, it could amplify the market highs and deepen the market lows. The good news, is that not only are we not even close to that situation, it will never happen.

Click to expand...

What is it that you're saying can't happen? Another major market crash?

[Perry Ict]

Jaqen Haghar, MD wrote:

Not a pyramid scheme, but I do sometimes wonder what (yet unforeseen) problem/crash will arise over time, as more and more people use an indexing strategy.

When people ask about the problems with passive investing through indexes, they get shut down pretty hard and responses get emotional quick.  (To me, not a great sign)

Most opponents against passive index investing have a vested interest in getting commissions from active investing, so info against it is often biased, and good info is scarce.

Still, when everyone piles into something, and fails to consider the downside risk, it can sometimes set up a future surprise disaster.

…But I still use mostly a passive investing strategy.

for now.

 

Click to expand...

Well said.  And what you said in bold worries me too.

[Zaphod]

nephron wrote:

I think that the op was talking about this phenomenon:

https://www.nytimes.com/2015/10/11/business/mutfund/the-ease-of-index-funds-comes-with-risk.html

 

I think that it was briefly discussed in one of the WCI podcasts as well.  In theory, if 100% of the investors become index fund investors, the market will become overvalued because everybody is just buying the same group of stocks blindly without any concern for their actual valuation.   The “bubble” would burst once everybody realizes that everybody was doing this?   Or maybe when someone realized that the value of an individual stock was being heavily overvalued because the index funds were purchasing them and increasing their value via supply demand rather then any intrinsic value to the stock?  It goes back to the “efficient market” hypothesis, in that if everyone is just buying the same stock because they are part of some index, their value will no longer reflect an efficient market because an index is not not efficient.   I do wonder if there may be some tipping point in the distant future when some 80-90% of the market is in passive indices.   I think that the market does need active traders to sell and buy individual stocks.  I would imagine that it’s going to be one of those things in the distant future that doesn’t happen in our lifetimes and doesn’t effect us, like “climate change” (just kidding).

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Usually the people pushing this kind of a narrative are active fund managers set to lose. In aggregate their is very little difference in market structure. If that scenario ever were to come about, it would create a huge arbitrage and people will take the other side.

[VagabondMD]

runfast00 wrote:

Exactly, better said than me.  If everyone is only indexing will it over value the stocks in the index.

Click to expand...

In theory, it could amplify the market highs and deepen the market lows. The good news, is that not only are we not even close to that situation, it will never happen.

[Peds]

runfast00 wrote:

If everyone is only indexing will it over value the stocks in the index.

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yes but this is an impossible scenario.