There is no doubt that for the investor who does not want to spend too much time in investing or is not sure about what he is doing, passive indexing is the most efficient thing they can do.
By indexing, you piggyback on the economy and you get whatever result the underyling economy will provide.
There is also no doubt that for every winning active manager, there will be one losing active manager.
However, I disagree with this :
If almost everybody goes to passive indexing, they are not piggybacking on the economy, they become the economy.
Let’s do a thought experiment and assume 99% of investor are indexing. Then there are mathematically much more buyers than sellers, since indexing is a buy and hold strategy. Then you have two consequences :
-The price of each share in the index invested by ETFs will go up, because everybody wants to buy them, and this, without any regards to the quality of the underlying business. This leads to a situation where every share that is in an investible index ETF is massively overpriced.
-On the contrary, any share that is not in an investible ETF will be massively underpriced because there is almost no buyer for them.
In other words, there is not any mechanism of price discovery anymore at this stage.
Eventually, some investors will realize that the dividends they are getting for the price of their shares are becoming lower and lower and that they are getting no returns since the price of their shares has become disconnected to the underlying businesses. They will start selling again , inducing a massive correction in the price of the index and massive losses for indexers.
In this thought experiment, the smart investors have just to buy the stocks not present in indexes and wait for dumb investor to realize that the index are too expensive and that they move again to other stocks.
In other words, if everybody goes investing, there will be a massive ETF bubble.
That is why I think it is a paradox to wish that everybody goes passive. If we want to be successful passive investors, we should not wish that everybody else does the same thing.
Michael Mauboussin was saying that in order to have efficient markets (a very important assumption for indexing), you need three conditions :
1 - A great diversity of different investors, with different opinions : true most of the time.
2 - A mechanism that enables to aggregate this diversity of opinions : this is the price of every share
3 - An incentive to be right : if you are right you win money, if you are wrong you lose money
Conditions 2 and 3 are almost always true. However, if everybody goes passive, condition 1 is not valid anymore.
When you have a lot of different opinions and you aggregate them, the errors tend to cancel each other and the general consensus tends to be quite effective (“wisdom of the crowd”). However, when everybody in the crowd has the same opinion, the errors don’t cancel each other but rather tends to add to themselves. (“Madness of the crowd”)
That is why I think it is very important that not everybody goes passive, or else you will have a massive bubble.
The more I read about this stuff, the more I get convinced that to successfully active manage investments, you have to have two things: (1) luck, (2) huge resources. If you don’t have these two, in long term you just voluntary transfer money to those that have these two things.
I agree that being a successful active investor is very difficult, however I am not sure if I agree with your two points.
Although some of the successful ones can of course benefit from luck (survivorship bias), I think there are enough counterexamples proving that luck was not involved in the success of all of them :
-For instance, Edward Thorp had positive returns 227 out of 230 consecutive months. if this was due to luck alone, we would estimate his chances to 1 out of 10 power 63. To put this probability in context, the odds of randomly selecting a specific atom in the earth would be about a trillion times better. Boy! this guy was lucky.
-In his famous article The super investors of Graham and Doddsville, Warren Buffett asks and explains brilliantly what is the part of luck present in the returns of many successful investors.
To be a successful active investor, Howard Marks says you have to :
1- Look at what is the general consensus
2- Say when the consensus is wrong
3- Be right
Part 2 and 3 are incredibly difficult.