Thinking About Stock Market Valuation and Popularity of Index Funds

I spent this morning reading and thinking about an interesting article at Philosophical Economics titled Diversification, Adaptation, and Stock Market Valuation, found via Jonathon of My Money Blog’s succinct summary The Growing Popularity of Index Funds and Higher Stock Valuations.

The entire article is worth reading, it’s a fun read and well written. Many of us rely, or plan to rely, on equity markets returning at least historical levels in order to be able to feed ourselves, our children, and our dogs. It’s worth thinking about the “fundamentals” that guide our plans, and think about whether they are well founded or not. At the least, all that thinking is a fun mental exercise.

My very brief summary of the argument presented in the article is that  low cost index funds growing in popularity is a form of the market becoming more efficient at allocating capital; the up/down side of this is that an efficient market should make issuing capital cheaper, namely in the form of lower equity returns going forward, as the risk premium investors demand is being reduced through easy diversification.

The author takes pains to note that this is what he thinks should happen, not necessarily what will happen (the future and humans being unknown and complex). Selecting a small bits from the article that highlight these two points:

My argument here is that the ability to broadly diversify equity exposure in a cost-effective manner reduces the excess return that equities need to offer in order to be competitive with safer asset classes.  In markets where such diversification is a ready option–for example, through low-cost indexing–valuations deserve to go higher. But that doesn’t mean that they actually will go higher.  Whether they actually will go higher is not determined by what “deserves” to happen, but by what buyers and sellers actually choose to do, what prices they agree to transact at.  They can agree to transact at whatever prices they want.

Your take away could be “stock markets returns are not going to be nearly as high as they have been historically, I’ll never be able to retire”, or “this is all academic arguing and has no real world consequences”. If you read the entire article, I’m interested to hear your take.

My main thought is that it’s an interesting argument, but despite whether you agree or not, it has no immediate actionable consequences (or at least easy ones). Investing in low cost, diversified funds still seems like the best choice as an easy, efficient, and effective way of building wealth (easy is key here, I am quite lazy).

Nobody wants to eat cat food in retirement.

If it turns out that stock market returns are lower than average, and put an end to our cushy early retirement plans, then least we can claim to not be surprised when we resort to eating cat food, and feeding cat food to our children and dogs. If stock market returns turn out to be at historical levels or higher, early retirement will continue to go off without a hitch, and it will be a pleasant surprise when you get to spend the next 60 years eating human food. Either way, there doesn’t seem to be anything (easy) that you can do about it except wait and see how things turn out.

As to the substance of the article itself, here’s a collection of my totally uninformed and unformed thoughts. (You would think that having uninformed and unformed thoughts would stop me from presenting my opinion, but it’s the Internet…)

The argument as presented ignores behavioral effects. If you look at any study of average investor return, you will see that while passive investments are efficient and a great way of getting access to market returns, most people are not disciplined buy and hold investors at all. I don’t know if this particular fact changes anything, but I have a feeling behavioral effects will have to be considered to fully understand how investor and the market interact.

You, or at least I, don’t invest in equities simply because they offer a risk premium over equities, you invest in equities because it represents part ownership in companies that can grow their profits through productivity and technological advances. You might argue that we won’t see continue to seeing productivity and technological gains on the same scale as before; or perhaps we will and are just measuring it wrong (is the average person spending fifty minutes a day on Facebook an advance on par with the development of the semiconductor?), these are the kind of questions I worry about if I think about the wealth building power of my investments,  not the increasing prevalence of index funds.  Even if productivity gains slow down, we can at least hope returns can be increased by the increasing shares of company profit going to shareholder? Current nationalistic backlash and arguments about equality aside notwithstanding, it seems better to be on the winning side and be invested in the market.

So in the end, what else can you do but stay the course and keep invested in low cost, diversified investments? Sorry for random rambling, but it’s a rainy Monday morning and I’m retired, and as I understand, ranting aimless about things is one of the things retired people do.

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2 Responses

  1. Jason K says:

    Keep an eye out for value and overall shareholder return, and switch investments accordingly. I’m invested mainly in internationals (Vanguard’s VXUS) because internationals have CAPE ratios less than US stocks. I also have about a 12% cash position. Warren Buffett says “cash [is] a call option with no expiration date, an option on every asset class, with no strike price.”

    • The MC says:

      Value weighted indexes are interesting to me, at least from a theoretical perspective. In practice, I don’t think I’ll do anything different than hold the cheapest index funds for US and international, with a value tilt, and rebalance occasionally. Hopefully that will capture enough of the the difference.
      If I was starting from scratch, and had access to equally cheap value weighted index funds (DFA?) I would certainly consider it. I think actively switching my positions would be too much work for lazy old me.

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