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Are index funds pyramid schemes?

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  • Avatar Perry Ict 
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    Status: Physician
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    Joined: 01/20/2019

    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.

    #220505 Reply
    Avatar Perry Ict 
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    Status: Physician
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    Joined: 01/20/2019
    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?

    #220509 Reply
    Vagabond MD Vagabond MD 
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    Status: Physician
    Posts: 3245
    Joined: 01/21/2016

    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).

    "Wealth is the slave of the wise man and the master of the fool.” -Seneca the Younger

    #220511 Reply
    Vagabond MD Vagabond MD 
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    Status: Physician
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    Joined: 01/21/2016
    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?

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

    "Wealth is the slave of the wise man and the master of the fool.” -Seneca the Younger

    #220512 Reply
    Avatar Perry Ict 
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    Status: Physician
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    Gotcha.  Probably true.

    #220515 Reply
    Liked by Vagabond MD
    Zaphod Zaphod 
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    Status: Physician, Small Business Owner
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    Joined: 01/12/2016

    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.

    #220522 Reply
    Liked by Tangler
    Avatar juststarting 
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    Earnest refinancing bonus

    My kids looooove this song from Teen Titans Go:  “Making my money, the pyramid scheme money…”

    #220535 Reply
    Avatar pulmdoc 
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    Status: Physician
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    Joined: 09/19/2016

    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.

    #220570 Reply
    hatton1 hatton1 
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    Status: Physician
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    Joined: 01/11/2016

    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.

    #220667 Reply
    Craigy Craigy 
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    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.
      • Hell, 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 marketif 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).

    LEVEL 1 WCI FORUM MEMBER.

    #220677 Reply
    Avatar Dusn 
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    Status: Physician
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    Joined: 01/02/2018

    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.

    #220683 Reply
    Zaphod Zaphod 
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    Status: Physician, Small Business Owner
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    Joined: 01/12/2016

    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.

    Click to expand…

    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.

    #220688 Reply
    IntensiveCareBear IntensiveCareBear 
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    Status: Physician
    Posts: 162
    Joined: 12/22/2018

    1) Indexing is fine (esp indexing + options). There may be a time when it lags alpha significantly (usually bull years), but for now, it’s close enough and much easier for the masses. I advise VOO or IVV or similar indexing to anyone who wants to buy and hold, not check the market, and get decent returns. Personally, I choose almost pure alpha with some indexes held only to sell options, but that’s just personal decision.

    2) All the places that sell index funds (or shares in general) couldn’t cash out 100% of accounts. You saw this with many big names in 2008. They depend on some constant cash inflow (401k, etc) to handle redemptions, so it has a touch of Ponzi to it. The broker houses definitely don’t hold shares in equal distribution and proportion to all deposits (eg, for every 10k shares VTI they sell, they don’t have 900 shares MSFT, 495 APPL, 92 AMZN, 452 WMT, 119 GOOGL, 292 FB, etc etc etc proportional to market cap for every S&P company). They simply buy in massive blocks of shares (yet charge clients fees for every little trade). If I buy 100 shares of YUM or MCD or even something expensive per share like GOOGL today, my broker doesn’t lift a finger… they just give me some from their “pool,” and then they buy or sell from the pool if many people are doing similar action on a stock or ETF.

    This is the same as banks or insurance companies or virtually anything else that is a financial product. They just have a small fraction of that to keep the ratios right, but they essentially do fractional lending. They’d all be belly-up if hit with a ton of big redemptions all at once. That goes for State Farm or Chase bank or Fidelity or any of them. Keep in mind who the fund managers and brokers work for and who signs their paychecks. Consider why they all preach buy and hold. “Take on the Street” by Levitt (former SEC chariman) is cheap book now and it’s the best I’ve read on the subject; it explains the market and things to be aware of if you’re interested. You can do fine enough with ignorance is bliss also, but please just don’t think the newsletters published by the brokerage companies or the magazines who run on ad revenues from those companies are sound unbiased financial advice to help you get the best overall returns.

    3) So yes, it is a scheme or scam in the sense that it would fall apart with widespread cashouts, but that will never actually happen… so it’s fine. Whales and foreign investors would scoop up the shares if they got cheap enough. Besides, if it did somehow crash completely, the shares would just fall and fall to almost zero value until they could actually meet redemptions, lol. The brokerages that are being somewhat responsible would just crash later than the more hyper-extended ones. But again, that’s just trivia… won’t happen. It is not a perfect system, but it is functional. All that said, the boomers will probably be selling a lot more stocks and bonds and houses than the millennials can buy in the fairly near future, though. That might get interesting with regards to market pricing and demand/supply (stocks and other markets also). We shall see.

    …”Don’t worry that the market goes up and down, just be very glad that it goes up and down.”

    "Hmm, that sounds risky." - motto of the middle class

    #220708 Reply

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