“Is there any scenario, with a reasonable probability of occurring, in which investing in index funds as one’s core mutual fund holdings would not be smart?” — Dana Nibby

No. Over the long run, the much-lower-expense-drag of the index funds give them a huge advantage over actively-managed funds. It’s like comparing horses with 20-pound jockeys versus horses with 150-popund jockeys.

“I.e. [he persists], what happens if everyone, more-or-less, gets the idea that investing in the S&P 500 is the thing to do; similar to the group-think of the ‘Fools’ running up the stock of Iomega. Wouldn’t that be an inherently unstable situation?”

Well, if literally everyone did it—and especially if they all chose just S&P 500 index funds rather than spreading their money across a broader range of index funds—then prices would become less rational and efficient, giving active managers a better chance of beating the index funds despite their higher expenses.

This is an argument for looking beyond just the S&P index funds, and, for that matter, beyond just the US market (of which the S&P 500 companies make up a large share).

But naturally, long before it got anywhere near the impossible extreme I just described, it would self-correct. People would see “bargains” outside the universe of indexed stocks. They would sell their index funds (driving the price of S&P stocks back down toward fairer valuations) and buy the bargains (driving up their price).

The paradox is that, on the one hand, we need investors and money managers actively trying to beat the market in order for the sum of their collective judgements to set sensible, rational stock prices. Yet, on the other hand, when they do, it becomes very hard for any of them consistently to beat the market, let alone by enough to justify (for example) 1.5% annual expense charges—150-pound jockeys.

 

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