Other replies were good. But I'll add my two cents.
Index investors are basically free riders off the information and research generated by active investors. Indexing basically works pretty well because the market's efficient.
An index investor just comes in and just pays whatever the current market price is and allocates in proportion to whatever current market valuations are. He doesn't even need to know anything about the underlying companies. "Microsoft? Never heard of it. But the market says it's worth 3.8% of all major American stocks, so I'll put 3.8% of my money in it"
Astonishingly, this mostly works out fine. In fact, just indexing is very likely to beat any sort of actively managed funds after taking fees into account. That's kind of incredible when you think about it.
And the reason it does work is because the active managers compete so fiercely with each other. They end up showing all their cards to the market. And all the information they have, and the research and the analysis winds up reflected in the publicly available stock prices. In effect active investors pay their managers big fat salaries to analyze stocks, and passive investors get nearly all the benefits without any of the costs.
> Astonishingly, this mostly works out fine. In fact, just indexing is very likely to beat any sort of actively managed funds after taking fees into account. That's kind of incredible when you think about it.
Well, what also works fine is picking (enough) random stocks and buying them for an equal amount of money.
That index funds base the allocation on market share is (in my understanding) not a method to increase performance, but to greatly simplify any rebalancing of the stock allocation. If the price of a stock changes, an index fund does have to do anything. The allocation will always automagically reflect the market cap of the stock - more or less by definition.
Every other allocation (e.g. equal weight) would need to rebalance every now and then to return to the initial allocation. This can be complicated and/or costly. However, it might still perform better than the market cap index: https://www.realizeyourretirement.com/comparison-sp-500-inde... (of course it might perform worse in the future).
The harsher reality is that most retail and professional investors have no business trying to be active investors.
Throwing darts is cheaper and safer for them.
Index investors are only really messing with the market if there’s more capital chasing fewer goods than there otherwise should be if they were being “active”, which isn’t proven.
Index investors are basically free riders off the information and research generated by active investors. Indexing basically works pretty well because the market's efficient.
An index investor just comes in and just pays whatever the current market price is and allocates in proportion to whatever current market valuations are. He doesn't even need to know anything about the underlying companies. "Microsoft? Never heard of it. But the market says it's worth 3.8% of all major American stocks, so I'll put 3.8% of my money in it"
Astonishingly, this mostly works out fine. In fact, just indexing is very likely to beat any sort of actively managed funds after taking fees into account. That's kind of incredible when you think about it.
And the reason it does work is because the active managers compete so fiercely with each other. They end up showing all their cards to the market. And all the information they have, and the research and the analysis winds up reflected in the publicly available stock prices. In effect active investors pay their managers big fat salaries to analyze stocks, and passive investors get nearly all the benefits without any of the costs.