The Growing Popularity of Index Funds and Higher Stock Valuations

I recently read (and re-read) a post at Philosophical Economics titled Diversification, Adaptation, and Stock Market Valuation, which serves both as an educational resource and an interesting argument for a new shift in stock investing. It’s rather lengthy and not written for novices, but it doesn’t require a finance or math degree either. I recommend reading it in full, but here are my notes.

#1 Diversification is good. Buying a single stock exposes you to the risk of your investment going to zero. Lots of companies have gone to zero. For a long-time, most people either bought individual stocks or bought funds that owned a limited number of individuals stocks. High risk leads to lower valuations and thus higher expected returns.

Buying a diversified basket of stocks provides good returns with greatly minimized risk of permanent capital loss. Here’s the dividend history of the S&P 500 from 1926-2016, adjusted for inflation:

#2 People are realizing that diversification is good. When Jack Bogle published Bogle on Mutual Funds in 1993, Vanguard was considered a big success after reaching $100 billion in assets. (I recently bought a first edition for my collection.) Today, Vanguard manages over $4 trillion in assets. Yes, 40 times as much.

In 2000, under 10% of asset were in index funds. Today, roughly 25% of the US stock market is now held in index funds with no signs of retreat. Nearly everyone has the ability to buy a basket of 500 to 3,000 stocks for just $5 a year per $10,000 invested.

#3 We are also seeing higher average equity valuations. Correlation or causation? If everyone starts to agree that low-cost index funds (and “closet” index funds) makes investing less risky, then shouldn’t lower expected risk lead to higher valuations, and thus lower future expected returns? It won’t be a straight line, but it could be a powerful overall trend.

A couple of excerpts:

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.

To summarize: over time, markets have developed an improved understanding of the nature of long-term equity returns. They’ve evolved increasingly efficient mechanisms and methodologies through which to manage the inherent risks in equities. These improvements provide a basis for average equity valuations to increase, which is something that has clearly been happening.

Definitely food for thought.