Thinking in Index Funds

If you want to buy stocks, you should probably invest in an index fund. An index fund is just a portfolio of shares that mirrors the wider market - if you buy Vanguard’s FTSE Global All Cap, you’re buying shares in 7,180 companies that are representative of global stocks as a whole. You won’t be buying shares in literally every company, but the index fund will perform the same as the wider market because the composition is the same as the wider market. American stocks weighted by market cap account for ~64% of stocks in the global stock market, and about 64% of stocks in the index fund you buy will be American, and so on. 

Why should you do this? Two reasons. One is that most people think that equity markets are basically efficient, meaning that try as you might, you can’t beat the market. If you reckon Apple will have a good year in 2023 because of the iCar or whatever it is they plan to release, that doesn’t matter. The market already knows about the iCar, and has adjusted the price of Apple stock accordingly. There’s a copypasta from r/WallStreetBets that explains this:

Don't even ask the question. The answer is yes, it's priced in. Think Amazon will beat the next earnings? That's already been priced in. You work at the drive thru for Mickey D's and found out that the burgers are made of human meat? Priced in. You think insiders don't already know that? The market is an all powerful, all encompassing being that knows the very inner workings of your subconscious before you were even born. Your very existence was priced in decades ago when the market was valuing Standard Oil's expected future earnings based on population growth that would lead to your birth, what age you would get a car, how many times you would drive your car every week, how many times you take the bus/train, etc. Anything you can think of has already been priced in, even the things you aren't thinking of. 

But the more fundamental reason to buy index funds, at least for me, is that I don’t want to spend a ton of my time thinking about which stocks are likely to go up and which stocks are likely to go down. I don’t care if the market might be consistently underpricing stocks that have done well recently (as adherents to momentum investing believe), I just wanna whack my money in the index and be done with it. Given that my reason for investing in index funds isn’t a firm belief that markets are always right, but rather it’s because I generally take the view that ‘I should just defer to other people here because I can’t be bothered to do the research’, I’m able to adopt a general attitude of ‘thinking in index funds’. 

What does this mean? Efficient Market Hypothesis only applies to index funds, but the basic idea that ‘other people are less lazy than me and have probably come up with some aggregation of their views that I can steal’ is something that applies to pretty much everything I want to learn about. Here are some examples of quasi-index funds:

• Thinking about which charities to donate to is long and difficult, and I’m probably not smart enough to do it properly anyway. But GiveWell does a load of research, so I should just donate to whatever charities they recommend as the most effective. 

• Thinking about who is going to win the next UK election is hard, so I’m just gonna defer to the betting odds and Britain Predicts rather than come up with some long explanation as to who is going to win and why. 

• I have no idea what to think about [topic x], so I’m just gonna browse Metaculus and assume that whatever odds they’ve given some outcome are roughly correct. This isn’t likely to be completely true, but for stuff that I don’t care about, this is a better approximation of the truth than what I will come up with through 20 minutes of half-hearted research.

• I don’t really know anything about economics, so if I want to get a rough idea of which economic ideas are likely to be right, I’ll just defer to IGM expert surveys.

These methods aren’t foolproof, but I still think not enough people defer to quasi-index funds. I don’t know that many people who immediately check Smarkets when they want to get a rough idea of what is likely to happen in politics, or who go to IGM when they want to get some idea about some economic concept, but most people probably should. The other insight here is if you want to figure out something about the world, trying to find an approximation of an index fund is often a better idea than just randomly Googling the topic and reading the top few op-eds.

Less strong than quasi-index funds are heuristics that operate as mental index funds. These can lead you down a bad path where you take some stupid view just because you came up with a heuristic that generally works, but it’s still better than the alternative of relying on the bullshit that you came up with in your mind. Heuristics worth relying on include (in increasing order of reliability):

• If the smart people I know consistently disagree with me about this, I should just defer to them unless I have a clear model of the incentive structure or cognitive bias that means they’re likely to be wrong. 

• If I read a very interesting book by a known contrarian writer who is taking on every other expert who has tackled the topic, I should defer to the experts even if I can’t think of a good argument against the author.

• Whatever Matthew Goodwin predicts, I should assume the opposite is likely to happen. (See Goodwin’s previous predictions here, here, and here).

Yes, you might be able to do better than these heuristics if you think really carefully about what is likely to happen, but who has time for that?