things burry cannot explain too well

Recently, Michael Burry made a comment which the investors seem have taken too seriously. The story is short, but has made the news big.

Burry rose to fame after he made loads of money predicting the crash of the housing bubble in 2008. He was made more famous by Michael Lewis through his book, the big short. So yeah, he is a great guy. 

But that does not mean whatever he says has to be sacrosanct. He makes mistakes too. In the story, he saying that index investing is proving to be bad. In fact, so bad that he is likening it to the subprime CDOs. 

I am not sure whether I have to feel sorry for him, or for those who believe him. There is one thing I have found short in the investors' mind: that they don't have their own conviction. That's a behavioral debt which often becomes too expensive. 

Well, Burry is saying that index investing is bad, because it does not support market price discovery. Because when too much cash chases the index, prices of all stocks - good, bad, and ugly - will shoot up. Because investors buy without any regard for the price and value of stocks. Because the index comprises of far too many small, bad businesses whose stocks do not have liquidity, and yet are priced high. And he says the crash will be ugly. 

Then he goes on to compare index investing with the synthetic asset-backed CDOs. Here I am not sure whether he is actually comparing the bubble to the bubble, or the index investing itself to the CDOs. If he did the latter, his blunder is more prominent, for the CDOs are based on disproportionate leverage, and the index stocks are not that much. So that aspect is never comparable. But let's give the benefit of doubt to Burry, and believe that he just said about the bubble, like any other bubble. 

Now coming back to his concerns regarding the bubble in the index investing, we all know that the economy and markets are like a cycle. They go up and down all the time. There are times when the prices shoot up so much that they have to eventually fall, and yet other times, the other way is true. When taken to extreme, the bubbles have to eventually lead to price fall, and the busts, price rise. And they always do. 

Also, the free market mechanism comes into play all the time. Let's suppose that the bubble crashes badly. When the prices of the index stocks go up disproportionately compared to their fundamentals, the crash is bound to happen. Remember the dot-com bust. After the crash, the good stocks represented by high quality businesses become cheap compared to their intrinsic value, and the bad stocks represented by poor quality businesses may remain somewhat expensive. The investors will shun the index and buy good quality stocks, and may even short poor quality stocks. The index will then eventually move towards becoming fairly priced, making the case for index investing. 

Let's assume that the index investors, after the crash, sell their index stocks and buy good stocks which became cheaper. After the continual demand, prices of good stocks will go higher, and value of the index will correct. Now we have the case for index investing again. Because of this free market mechanism, even those index investors, who do not sell after the index bubble and crash, will also benefit by staying put on the index investing.

In fact, that is the essence of index investing: to keep going during both good times and bad times, pushing the average price of index units lower, and getting a reasonable market return. I can even say that a good index investor can achieve a return slightly higher than the market by increasing buys during bad times. But that's another story.

The hedgers, speculators, and short-sellers are always alert in a free market, and they take advantage of all arbitrage opportunities ensuring that the price and value of stocks and, therefore, the index are never too far off, for too long.

I am surprised Burry missed this point big time. We should be asking him where else to put money if not the index. The treasuries and high quality corporate bonds yield much lower. Junk bonds are not an option for the real investors. We have two choices then: Pick the stocks, or go to the index. 

Picking stocks is not for everybody. It requires time, interest, skill, and behavior. Index investing is for everyone who cannot be a stock picker, for the investor is assured of the market returns. 

For someone who has at least a decade of investing ahead, index makes the perfect choice. Once the horizon becomes shorter, asset allocation will have to come into play. A right mix of the treasuries, high quality bonds, and the index should take care of the investor's cash requirements for the rest of life.

The fun part is that we are not even close to all-passive investing. There is huge money actively and continually chasing stocks all the time, and I believe that as much as we know of the human behavior, we have a very long way to go against it. The fear, greed, and envy will ensure that active investing will stay for a long time, and index investing will continue to give market returns for those who find it satisfactory.

It is far better to use common sense and wisdom than borrowed conviction. Life and investing then will be rewarding.