Does Passive Investing Increase Market Volatility Risks

I figured this community would be interested in this discussion.

It's just noise. I watch it with curiosity.

I reached 200k a month or so ago. Now sitting on 218k invested in sp500 and msci world which means 1.5% up or down translates to a gain or lose of 3k which is a lot for me cause I make 2k net a month.

So in a typical day my portfolio is up or down what I make in 1.5 months working full time

How does it affect you ? Does it change your mood ?

Sorry for the very long question. I have been thinking about this for a while and I want to know if this makes sense of if it's just crap.

I think there are many things breaking the stock market right now, many of them are well-known (inflation, oil shock, AI bubble) but I feel a far more general irrationality right now in the market, which I hear pretty much nobody talk about.

So, firstly, in the last 2 decades there has been a massive increase in passive investments. So many people store their money in Vanguard All-World or S&P500 or whatever generic ETF which is just supposed to follow the market. Many people do this passively, have a monthly sum automatically deposited without any manual action. I think this fundamentally ruins the markets in several ways.

First of all, people investing passively are not picking stocks. They're not looking at the valuations, they're not looking at the earnings. It's just "do whatever the market does, it'll probably be fine". I wonder if we have passed a point where the amount of money "following" the market has become far more influential than the amount of money actually looking at earnings. Most institutions are probably also just following the market since everybody knows it's madness to try and beat it yourself.

This is combined with the rise of algorithm trading, which is probably another substantial part of the people who are still trading actively. They just parse news and try to act on it as quick as they can. While in normal circumstances that does seem to make sense, Trump and companies have clearly started to take advantage of this, by flooding the airwaves. This is also the reason for all these fake announcements.

This all leads to an incredible amount of money in the market essentially following themselves in a circle, and there is a huge inflow of money every day to do this same thing.

Now, this all leads to something for which I don't quite have the right vocabulary, and don't know enough about economics and financing to know if I'm right at all. The stock market is measured in dollars. We often forget this, because we look at percentages up and down, but it represents the value in dollars. If the amount of money in a system grows very hard, money should lose it's value correspondingly. What is happening in the stock market is that there has for decades, since the Great Recession and maybe longer, been a massive amount of inflation, but just in the stock market. There is a massive amount of money which is just circulating there, only increasing. This is not measured in inflation, since those measure normal products, not stocks. A dollar in the stock market is losing value far quicker than a dollar outside of it.

What I fear is that in the event of a recession, people will stop depositing money passively. They might even withdraw money, to buy gas, to pay rent, to buy tomatoes. If this happens, all that money, all the quantitative easing and extra money, will finally be released, decades too late, into the economy as a whole. This will lead to a massive crash in the stock market, since people are thinking "hey that dollar over there is far less usefull than a dollar here", which will lead to massive inflation in a very short time span. Suddenly all the money captured in the stock market gets released all at once.

Can anyone tell me why this is wrong? What am I misunderstanding, what mistake am I making? I would assume I'm not the smartest guy on the planet and if this is true more people should already have reached this conclusion.

I'm at a point where in one month it can go up or down in an amount greater than my annual salary. Which is great when it's up!

I look at my account balances once a month and otherwise try not to think about it.

No. It takes very few active traders to make the price move. This is part of why it is do difficult to beat the market. News is reflected in price very swiftly.

I find myself sitting at work making $300 or whatever a day, watching my portfolio swing $3k in an afternoon. Like damn that was 2 week's worth of work. Then it swings back. Odd feeling. The solution is to not look every 2 hours but I'm sadistic.

Passive investing doesn’t “break” the market because passive funds are price-takers, and prices are still set at the margin by active investors and arbitrage. If indexing ever created big, persistent mispricings, it would literally become easier (more profitable) for active money to correct them, which pulls capital back into active. There are real effects like more comovement and some demand-driven price pressure, but that’s different from “the market is fundamentally broken.”

This has been thoroughly researched. The consensus is it's not a worry. Passive investing would have to be an enormous majority of held assets, and only a small amount of volume is enough to move prices meaningfully. Also, if we ever approached that, active investing would again show a meaningful profitability and more people would go in that direction.

TL;DR: Not a worry.

Long question so you have a lot in it.

I will advise the following regarding passive index investing.

Read the book: Random Walk Down Wall Street.

It was written in the 70s and it was one of my textbooks when I took finance classes in the early 80s. My understanding it is still widely used as a textbook as it is that widely respected.

That book is credited with the creation of low cost index funds that are so popular. His claim that he shows the data for is the idea a person can'lbeat the market constantly is false. He makes a very strong case you can't beat the market and why.

The book is very readable.

It is the only finance class textbook still on my bookshelf all these decades later.

My point is I don't think passive low fee index investing is a problem. I also think if you are regularly investing and the market goes down people shoukd see it as a time they are buying stocks on the cheap. The typical recovery period from a bear market isn't that many years.

After the 2008-09 bear market it had fully recovered by 2012. Selling during the bear market was the wrong choice. Many did well buying not selling. So no I don't forsee a huge rush to get out if it happens again.

Hello everyone,

My investment journey started one year ago. One of the major pillars I had in my mind was that I would not go fully in the markets until I understand what I was about to do. So, I started to read in the Internet, read some books and papers, listen to some podcasts .. It has been an enrichment experience!
For sure that I don't dominate the area and most of the times I need a confirmation from someone, like ChatGPT or users users :)

Soooo, question of the day: does volatility and drawdowns represent risk? My view:
1) Yes, on a psicological and behaviour perspective. People panic and try to minimize their losses, get out and return to the market later, etc.
2) No, if you are literate in the topic and absorbed the right ideas. Volatility is nothing, just temporary oscillations that in fact represent opportunities to buy dips.

I have been a bit skeptical about my current portfolio, as I naturally prefer to keep it simple and avoid risky stuff. I started with 100% FTSE All World ETF, and I recently added 15% World Small Cap Value and 15% World Momentum.
I am not going to lie, but it goes a bit against my initial view of risk avoidence profile and I considered to go back to the initial portfolio or to add some other factors, like Quality and Minimum Volatility ETFs. Well, it happens that now I don't care about volatility.

Just to complete and finish my strategy, I intend to monthly DCA in the underweight ETF in order to keep the right % allocation. I considered also to rebalancing my selling a small % of outperformed ETF and reallocate to another, but it might not be fiscally efficient.
Before 10years of retirement, I will add short bonds and start to weight it through time.

Thank you. All your hints will dissipate any doubt I might have or contribute to other perspectives I did not consider until now!

On one hand….
What makes you think their analysis is correct?!?

Can you name at least three significant factors they haven’t taken into consideration in their analysis?!?

The problem with these kinds of analyses that come with headline type warnings is that they’re reductive by definition. The authors attempt to predict the market based on limited assumptions and limited inputs. And that’s not how the market works.

On the other hand….
They might be spot on.

Final analysis… nobody knows nuthin’

The more I learn about investing, the more I feel like people often use volatility and risk as if they mean the same thing.

But I’m not sure they do.

Volatility tells us how much price moves.
Risk seems deeper than that — more about the chance of permanent loss.

Those two can overlap.
But they don’t always mean the same thing.

Some very volatile investments turn out fine over the long run.
And some calm-looking ones turn out to be fragile underneath.

So I’m curious how people here think about it:

When you hear “risk,” do you mostly think about price swings — or something deeper?

Here's a thought exercise to see how people can change their view of volatility over time. This thought exercise is not specific to you, and your situation may differ from it. I'm providing it for perspective, not a suggestion on what you should do.

Let's imagine a new investor with a $5K portfolio. They have a $50K/year job, and they save diligently 10% of their income ($5K/year). If their portfolio loses half of it's value (very plausible historically), then their portfolio will return to $5K value in only 6 months even if the market does nothing. That's probably not a big deal for them - in fact, they may come out of it viewing themselves as a stronger investor for "surviving" that volatility.

Let's imagine that same person 15 years later. They have a $80K/year job now, and they have managed to increase their savings rate to 15% of their income ($12K/year) because they want to retire early. Their portfolio is doing well, and they now have a $150K portfolio. If their portfolio loses half of it's value, now it'll take 5 years for the portfolio to return to $150K value if the market does nothing. That gets a bit intimidating, but said person probably realizes the market will return eventually by itself, and they have a long time until they want to retire anyway.

Let's imagine that same person closer to retirement. They have a $120K/year job now, and they now save 20% of their income ($24K/year). They want to retire with $80K/year income, and they have a $2M portfolio prepared for that. When their portfolio drops 50% of value, now it'll take them almost 42 years for them to contribute to get to their original value. They were planning on retiring - they don't have that 42 years. They may very well be dead in 42 years. Said person is radically impacted by market volatility, and may have to delay their retirement by 5-10 years (or more) due to market drops. For instance, after the Great Depression, the USA experienced >20 years of 0% real stock market returns.

Let's imagine that same person in retirement. They are pulling $80K/year from their $2M portfolio. When their portfolio drops 50% of it's value, they have no income at all, and are entirely dependent on the market for recovery. How do you think they feel in that case, when their portfolio is rapidly depleting at 8% withdrawal rates ($80K/year on $1M), and they have no income at all to contribute to their portfolio?

Hi everyone,

I’m reviewing my portfolio and would really appreciate some input.

Right now I’m allocated like this:

20% Small Cap Value

20% Momentum

20% Quality

20% Minimum Volatility (that I was thinking about removing)

20% Classic market-cap weighted (CAPM-style index)

I’m considering whether to remove my Minimum Volatility allocation, especially given that I already have exposure to multiple factors.

My main question is about the very long term (30+ years).

From what I understand:

Factors like Quality already tilt toward more stable companies

A diversified multi-factor portfolio should already reduce volatility to some extent

Minimum Volatility seems more useful for drawdown control than for maximizing long-term returns

So I’m wondering:

Is Minimum Volatility basically redundant in a setup like this?

Does it still add meaningful diversification, or is there too much overlap (especially with Quality)?

For a 30+ year horizon, does it actually make sense to keep it, or is it just sacrificing expected returns for smoother short-term performance?

I’m not too concerned about short term volatility and I’m comfortable with drawdowns if the long-term expected return is higher.

Curious to hear your thoughts, especially if you’ve built or analyzed similar multi-factor portfolios.

Thanks!

Is this not the same issue that has been brought up for years now? If too much investing is passive then it will increase price discovery making active investing more lucrative. The balance is somewhat natural in this respect but you will always have people who believe they can beat the market. They’ll remain active to a certain point.

Another way to look at it is to picture active investing as shark infested waters. Everyone believes they are the apex predator going to dominate. However, eventually someone eats their lunch and scares them into passive investing leaving the most cutthroat sharks in the water. Everyone who remains active is more and more difficult to beat because they really are the most cutthroat of them all.

That paper’s been making the rounds, and while the math sounds spooky on paper I’m not losing sleep over some 65% threshold we’re nowhere near yet

Volatility can be a plus, if you are in a tax free account and can sell the daily profits and wait for the collapse to re-buy. Been doing this with NVDA for a year and am up over 200k.

I know this topic has been talked before in this subreddit

And what was the consensus then? Wasn't it that only a small number of active trades are required to keep the index going, and that if there was an opportunity to outperform the index, the active participants would quickly arbitrage that away, so it's a self-correcting "problem"

What do you think will happen if passive ETFs come to own at least 51% in a lot of companies?

Why do you think this could be a problem?

more concerned about the governments taking action

Why would a government view this as an issue?

You’ve got the right mindset already..  volatility isn’t the same as risk unless you let emotions turn it into one. Actual risk is the chance of permanent capital loss, not temporary swings. If you’re diversified, long-term focused, and disciplined with DCA/rebalancing, volatility just becomes noise or even opportunity.

They are not the same thing but they are related. Security's volatility is a risk, meaning if you need the money at any given point, it's volatility would make it higher chance that you would sell after it drops. So I think people are using the terms interchangeably more or less is referring to that specific kind of risk.

You’ve hit the nail on the head. Actual risk typically cannot be quantified which makes it hard to write academic quantitative papers or measure the supposed de-risking of diversification. But volatility is easy to measure! So ”we” use that as a measure of risk. Which it mostly is not.

Volatility is not risk by itself. It becomes risk when it interacts with your situation. When you say risk, it’s more about permanent impairment, forced selling, loss of purchasing power, and failure to meet the goal the money was meant for. The better question is under what conditions would volatility actually hurt me?

If you own a diversified equity fund and won’t touch it for 20 years, volatility is mostly a psychological problem. If you’re leveraged, need the money soon, or are drawing income from the portfolio, volatility can become very real risk.

I was wondering, that if passive index investing became so dominant that it was well over 80% of the US stock market, wouldn't that have an adverse effect on the market as a whole as there's a lack of investors testing the waters so to speak, i'm not sure of the technical term for that, or have some other adverse effect on it being an efficient market?

Like it could lead to a situation of big boys getting bigger just because they're big, but not because of their fundamentals?

We are a very long way from passive indexing dominating the market. Even if passive indexing becomes dominant, theoretically this should create inefficiencies in the market for active investors to exploit, which will bring the market back into equilibrium. Even if passive indexing becomes problematic and active investors can’t correct for it, there is nothing with a positive EV I can do about it now.

So… I give it exactly zero thought and focus my energy
on things that I can control.