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ADVERTISING DISCLOSURE Anyone who’s been to our site for longer than 3 seconds knows we LOVE index funds. In fact we rely on index funds as our primary investments. However, some investors fear that index funds will cause the stock market to break. Namely, what if everyone invested in index funds? But before we dig into that, let’s define explore the benefits of index funds and then define what they are.
4 Reasons We Love Index Funds
- You are guaranteed to earn market returns (something that half of PROFESSIONAL investment professionals can’t do)
- You pay much lower fees and taxes than if you were moving in and out of individual stocks
- It’s so simple to choose awesome index funds to invest in.
- With the advent of target date funds, you can even simplify your investments and own a single index fund.
What Are Index Funds?
A stock index fund is simply a group of stocks that you can buy as a single bundle. The most popular index funds are built to track a specific index like the S&P 500. By purchasing an index fund, you will own a whole group of stocks. (Bond index funds also exist, but let’s focus on stocks to keep things more simple.)
Owning an index fund like an S&P 500 index fund provides diversification because you will, in essence, own small slivers of 500 different companies, instead of only a handful. Diversification basically means spreading your money out among many investments. By doing this, you reduce the riskiness of your portfolio. In other words, you lower the chance that you’ll lose A LOT of you wealth due to a few of your investments losing value while not meaningfully lowering your returns. The power of diversification will protect your portfolio from the risk of picking the ‘wrong’ stocks. In your index fund, some stocks may go up while some will go down in value. But historically, the broader stock market has always increased over long periods of time. This is why they are such a wonderful way to invest.
Here’s why you shouldn’t buy individual stocks!
Could The Stock Market ‘Break’ If Everyone Invested In Index Funds?
In theory, yes. But in reality that won’t be happening any time soon for a few reasons.
The prices of stocks in the stock market are set via supply and demand. There’s essentially an invisible electronic middle man who matches buyers and sellers who place bids for stocks at certain prices. As the computers match buyers and sellers, the current stock price will move up and down to the current price at which people are willing to buy and sell.
For example, let assume you own Tesla stock that you want to sell and it’s currently trading for $280. You are welcome to place a sell order at a price of $350. However, if no one else believes that Tesla is worth $350 then you probably will not be able to sell your shares for $350. You’ll then have to keep lowering your asking price until someone is agrees with your price. This is a high level example of how the market determines stock prices.
Some people worry that if everyone decides to only invest using index funds, then the stock market will stop working. For example, if everyone buys index funds, the values of the stock prices of the underlying companies won’t reflect the fair value of the companies in the stock market. Instead the prices of stocks will simply reflect the the inflow of funds to indexes.
Do Index Funds Help Determine The Fair Price Of Stocks?
No, index funds don’t participate in the price discovery process in the same way as the traditional practice of buying and selling individual stocks. At a basic level, index funds are pools of money that buy groups stocks in certain proportions at the current stock market price. They don’t take a view on what the price of a stock should be. They simply buy an entire group of stocks when investors invest money into the index fund.
What this means is that if every investor in the world only purchased the same index fund, then the market of buyers and sellers would no longer set the fair market price of the stocks in the stock market. In a sense, the stock market would no longer be a “market”.
Remember, picking individual stocks is for dummies.
What If Everyone Invested In Index Funds Funds?
In theory, it’s a valid concern that uniform adoption of index funds could cause the market to stop working efficiently. However, the vast majority of the public stock market would have to be held by index investors for the market to break down and stop working as intended. Economist Larry Swedroe, for example, believes that index fund ownership would need to account for more than 90% of all stock ownership for index funds to cause a problem.
According to Bloomberg, index funds only own 18% of the stock market. In other word, we still have a long way to go before we really need to worry about index funds causing problems. Index funds were created by John Bogle at Vanguard in the mid 1970’s, so if the past 45 years are any indication, there is still A LOT of time before index fund ownership gets anywhere close to 90% of all stocks.
Do You Own Index Funds?
FAQs
If everyone invested equally in the stock market, the value of these stocks would neither go up nor down. This is because an equal investment in the stock market results in the lack of prices, which are the driving forces of stock value. Again, it is quite tricky always to have a win-win situation in the stock market.
What happens if all investors are passive? ›
What's worse about this is not that you as an investor have no choice but to expose yourself to bad companies but that, if we were all passive investors, there would be no mechanism to adequately value companies in the market based on their business, and therefore, it would be virtually impossible to trust the values ...
What is the main disadvantage of investing in index funds? ›
The benefits of index investing include low cost, requires little financial knowledge, convenience, and provides diversification. Disadvantages include the lack of downside protection, no choice in index composition, and it cannot beat the market (by definition).
What happens when you invest in index funds? ›
Index mutual funds pool money to buy a portfolio of stocks or bonds. Investors buy shares directly from the mutual fund company at the net asset value (NAV) price, which is calculated at the end of each trading day.
Why doesn't everyone invest in index funds? ›
Another reason some investors don't invest in index funds is that they may have a preference for investing in a particular industry or sector. Index funds are designed to provide exposure to broad market indices, which may not align with an investor's specific interests or values.
What if everyone invests? ›
If “everyone invested more money into the stock market” it would cause stock prices to go up. Higher stock prices would make it easier to make money through capital gains but harder to make money through dividends because you would have to pay more for a share.
What happens if everyone buys ETFs? ›
If a preponderance of investors do not trade individual stocks but invest in index ETFs, price discovery for the stocks constitute and index may become less efficient. In the worst case, if everybody owns just ETFs, then nobody is left to price the component stocks and thus the market breaks.
Can investors lose their entire investment in stocks? ›
A drop in price to zero means the investor loses his or her entire investment: a return of -100%. To summarize, yes, a stock can lose its entire value. However, depending on the investor's position, the drop to worthlessness can be either good (short positions) or bad (long positions).
Is it possible for a regular investor to beat the stock market? ›
Regular investors have some advantages over professionals. It is clear from the statistics that beating the market is incredibly hard. Even most professional investors are unable to do it. Because of this, it seems logical that most regular investors would also be unable to beat the market over the long-term.
Do billionaires invest in index funds? ›
It's easy to see why S&P 500 index funds are so popular with the billionaire investor class. The S&P 500 has a long history of delivering strong returns, averaging 9% annually over 150 years. In other words, it's hard to find an investment with a better track record than the U.S. stock market.
The important thing to remember about index funds is that they should be long-term holds. This means that a short-term recession should not affect your investments.
Is it wise to only invest in index funds? ›
Investing legend Warren Buffett has said that the average investor need only invest in a broad stock market index to be properly diversified. However, you can easily customize your fund mix if you want additional exposure to specific markets in your portfolio.
How do you actually make money from index funds? ›
As with other mutual funds, when you buy shares in an index fund you're pooling your money with other investors. The pool of money is used to purchase a portfolio of assets that duplicates the performance of the target index. Dividends, interest and capital gains are paid out to investors regularly.
Do index funds pay you? ›
Most index funds pay dividends to their shareholders. Since the index fund tracks a specific index in the market (like the S&P 500), the index fund will also contain a proportionate amount of investments in stocks. For index funds that distribute dividends, many pay them out quarterly or annually.
Are index funds really worth it? ›
Index funds are popular with investors because they promise ownership of a wide variety of stocks, greater diversification and lower risk – usually all at a low cost. That's why many investors, especially beginners, find index funds to be superior investments to individual stocks.
What happens if nobody is selling a stock? ›
It's important to address the question: What happens if no one sells a stock? Well, if there are no sellers, the market can experience a lack of liquidity and reduced trading activity. This can lead to limited opportunities for buyers to acquire stocks and potentially impact the overall functioning of the market.
What would happen if there were no stocks? ›
A nation without a stock market could see more even income levels between the upper and the middle class. However, the overall economy might not be as strong, and many of our major corporations would not exist, at least not as we know them.
What would happen if there was no trading? ›
Trade allows economies to specialize and thus they can produce more goods. The standard of life would fall significantly across the world and many people would fall into poverty. However, this does hurt some countries more than others.
What happens if there are no buyers for an option? ›
Assuming you have sold a call option and you find no buyers, this can happen in below cases: Your strike has become deep In The Money. And hence, if you are not able to square off the position, you option will be squared off automatically at expiry and you will incur a loss. You strike has become deep Out of The Money.
