I’ve secretly struggled with one particular thought experiment ever since I started my financial education. Basically, the thought experiment is: What would happen if everyone invested in index funds? If 100% of stock investors invested in index funds, things would just go crazy. The stock market would collapse, right?

I honestly couldn’t wrap my head around it.

I mean, I knew that active investing net (after taxes and fees) underperforms a passive approach using index funds 80% of the time in a risk adjusted manner. But, in order for passive investing to work, don’t we need active investors? The light requires the dark, right? A Star Wars type balance in the Force.

It took until recently and the work of someone smarter for me to figure out the answer. And if the stock market would actually collapse…

Why the stock market would collapse if everyone invested in index funds

There were 3 main reasons, at least in my head, that I figured would cause the stock market to collapse if we all just invested in index funds.

1. No way for individual stocks to go up and down if buyer doesn’t set price

This was the main thing that flummoxed me. Based on peer reviewed research and people smarter than me, I firmly believe that the stock market is efficient.

But it is not 100% efficient. It’s still too efficient for any anomalies to be consistently exploited beyond that expected by random chance. But there are minute inefficiencies that still exist.

And the investors who try to exploit these minute inefficiencies (even though they cannot do so better than chance would suggest) are active investors. And, in fact, it’s these active investors that are probably making the stock market even more efficient every moment.

Ergo, without these active investors chasing the elusive and (highly likely) unachievable alpha in the market, what happens?

There would be no one on Wall Street trying to set these, largely arbitrary, stock prices. And then what?

The whole system falls apart, right?!

More on why this assumption is incorrect to come below…

2. Everyone would invest in a total stock market index fund

When I think of everyone investing in index funds, I guess my assumption without realizing it was that everyone would invest in a total stock market index fund. I assumed this mainly because this is the most index-y of all index funds.

But assuming this muddled my thinking because it made it even more difficult for me to get over the hump of figuring out how prices would be set in the stock market if everyone just owned all the stocks.

And while there is a solution to that mind-bender, this assumption is all wrong anyway.

An index fund is a mutual fund that faithfully follows its appropriate index. This obviously fits a total stock market index fund. But it also includes things like an S&P 500 index fund that follows the S&P 500. Or a good index fund focusing on U.S. small value stocks that may follow the MSCI US Small Cap Value Index. And so on and so on…

Obviously if one index performed better than another after risk adjustment, there would be more investors in that index fund. Naturally. Over time, these inefficiencies would also work themselves out.

But this process would set the prices of the stocks within the indices themselves in this hypothetical utopia of only index fund investors…

3. Equal representation of companies over time

This was another assumption of mine that bothered me for a while. If everyone invested in index funds, how could individual prices be set and things go up and down if everyone just always owned every company trading publicly?

But this assumed everything existed in a vacuum. And that there was no growth or attrition within actual companies. But that is not how the economic market in the world works.

New companies gain advantages and grow. Old companies stagnate and contract. This will result in a consistent flux of new companies entering indices and old ones falling out.

And the index is a sum of all of its parts. Even if one company in the index is doing great, the entire index will not be priced to reflect just that company. It also has to reflect the fledging companies in the index as well.

In essence, that’s why investing in index funds work. You are placing your trust and money on not just one or a few companies succeeding, but on the entirety of the U.S. (or world) economy succeeding.

And that is a much safer bet.

But still, even if these assumptions were incorrect, wouldn’t having all investors invest in only index funds throw things majorly out of whack, if not collapse the stock market?

Let’s add some numbers to our through experiment

Let’s go back to this numerical experiment first introduced by Nobel laureate William Sharpe in 1991…

Sharpe asserts in his argument that active and passive stock management must be “sensible.”

This, in his proof, the following must be true:

• Before expense (i.e. fees and taxes) returns on the average actively managed dollar will be the same as before expenses returns on the average passively managed dollar, and
• After expenses returns on the average actively managed dollar will be the less as before expenses returns on the average passively managed dollar

The proof here is that active stock management, in aggregate, is a loser’s game.

In the stock market, there are only two types of investors: active investors and passive investors.

Let’s assume that:

• 70% of investors are active and therefore 30% are passive
• The market returns 10% i.e. a total stock market index fund earns 10% returns before expenses

The question then becomes, what before expenses rate of return, must active managers earn in this case?

And we can actually figure this out due to the simple mathematical concept that the sum of the parts must equal the whole.

In this case, the total stock market in sum (A) is equal to all of the active investors (B) plus all of the passive investors (C).

A = B + C

Now let’s factor in the rate of return before expenses, X. And we already know that the rate of return pre-expense for the total market and for passive investors is 10% in this case. The only variable we don’t know yet is the pre-expense return for active stock management.

So,

10% (100%) = X% (70%) + 10% (30%)

And we can solve this equation,

10% = X% (70%) + 3%
7% = X% (70%)
X = 10%

We did it! We just proved the very first assumption that Sharpe makes in this proof. That before expense (i.e. fees and taxes) returns on the average actively managed dollar will be the same as before expenses returns on the average passively managed dollar.

With this proven, we already know the second point that after expenses returns for active stock management are lower must be true. Because active management incurs additional fees and taxes due to increased trading and management.

But what does this have to do with everyone investing in index funds?!

That’s the beauty of this whole proof! It works no matter what percentages you use!

So, let’s look at it again.

The total stock market in sum (A) is equal to all of the active investors (B) plus all of the passive investors (C).

A = B + C

Now let’s factor in the rate of return before expenses, X. And we already know that the rate of return pre-expense for the total market is 10% in this example. And now let’s say that passive investors represent 100% of the market in this case. Thus, active investors represent 0%. The only variable we don’t know is yet again the pre-expense return for active stock management.

So,

10% (100%) = X% (0%) + 10% (100%)

Without getting into the limits of infinity and math that I don’t fully understand, this proof still shows that, when all investors invest passively, the market return for active investors is irrelevant. It could theoretically be any number – positive or negative – and the results would be the same – the market returns equal the returns of passive investors.

The stock market doesn’t collapse.

You can see a full discussion of this proof here.

Why the stock market won’t collapse if everyone invests in index funds

Imagine if everyone invested in index funds. It’s easy if you try. I almost feel like this should have been a concept added to John Lennon’s famous song, Imagine.

There would be no lower returns (in aggregate) due to fees and taxes.

There would be no speculation masquerading as investing.

And there would be more time for investors to focus on what really matters in their lives – personally and professionally.

Plus the stock market wouldn’t collapse in on itself.

It almost sounds too good to be true

And unfortunately it probably is. As long as investors perceive that there could be an iota of inefficiency that they can exploit, some proportion of them will seek it out. Ultimately to their own detriment.

But that doesn’t mean that you have to. You can develop a written personal financial plan like mine, create a savings rate of at least 20% of your gross income, invest in index funds according to your asset allocation, and place yourself firmly on the path to financial freedom!

What do you think? Would the stock market collapse if everyone invested in index funds? What would happen? Let me know in the comments below!