I own index funds and see how they're logical for someone who isn't a financial genius or doesn't have insider knowledge (99.999% of the population). The question that keeps nagging at me is whether or not this will always be the case.

At a certain point, won't all of this buying that's based on nothing more than market cap lead to some problems?

It seems like index investing makes sense when a small number of people do it, but if everyone jumps on the bandwagon, won't we start seeing valuations that have no basis in reason, and won't the whole market will become increasingly correlated and subject to radical swings?

I was just reading about this yesterday:http://www.psyfitec.com/2012/03/hubble-bubble-index-trouble.html

It goes both ways.

The shift to index investing seems to be having an impact on volatility as well.

It is also the case that the ability of shareholders to hold a company accountable, which is a critically important role, has greatly diminished in recent years. But the flip side of that is that the general public has more influence on corporate behavior and that is widely viewed as a positive.

As an individual investor I don't think you should be worried. We are a long way from anything seriously disastrous happening because of index investing.

That was extremely interesting, particularly the part about an index fund bubble possibly masking the usefulness of active management.



I feel that this is probably the case, but I'm 25 and my retirement is a long way off. It seems feasible to me that a major crash related to this could occur within the decades between now and then.

I don't really buy it. If everyone bought index funds, certainly indexing would lose it's effectiveness. But given that only 10% of the US investment market is in S&P500 Index funds, I seriously doubt that this problem would be upon us any time soon.

The article above explains a lot about why index funds are typically weighted by market cap and why being included in an index doesn't automatically mean that a stock will outperform.