Passive Stampede?

LAST WEEK, investment manager Michael Burry made waves when he issued an apocalyptic forecast: Index funds, he said, are in a bubble similar to the housing bubble that ended very badly in 2008. Burry couldn’t say when the crash would come, but noted ominously that, “the longer it goes on, the worse the crash will be.”

Burry acknowledged that he’s “100% focused on stock picking,” so—at first glance—his criticism seems not unlike other active fund managers’ criticisms of index funds, sometimes referred to as “passive investing.” Competitors have been lobbing grenades at indexing since its inception nearly 50 years ago, when one active manager called index funds “un-American.”

But Burry isn’t just any ordinary stock-picker. He’s a cult hero within financial circles. A neurologist by training, Burry left medicine to start a hedge fund and was one of a handful of investors to predict the 2008 crash in mortgage bonds—and to profit from it. In The Big Short, his book on the topic, Michael Lewis cast Burry as a central character. In short, Burry is exceptionally talented, with a track record that speaks for itself. It’s no surprise then that last week, when he issued his broadside against index funds, people listened.

In Burry’s view, the growth of index funds presents several dangers. First, they use derivatives, “the same fundamental concept that resulted in the market meltdowns in 2008.” He cautioned that index funds could face a liquidity crunch. “The theater keeps getting more crowded,” he said, “but the exit door is the same as it always was.”

That last line was the one that really got people. No one likes the idea of being stuck, especially when it comes to one’s finances. And no one likes the idea of getting caught in a stampede.

While I disagree with Burry’s doomsday forecast, I’d like to discuss a broader issue here. My peers Allan Roth and Ben Carlson have done, I think, the best job of responding to Burry’s comments point by point. Vanguard Group also addresses some of Burry’s criticisms in this paper. I recommend reading what they have to say.

The broader issue, in my view, is our propensity as humans to buy into narratives like Burry’s. As Jonathan Gottschall wrote in The Storytelling Animal, “We are, as a species, addicted to story. Even when the body goes to sleep, the mind stays awake all night, telling itself stories.”

Writing in Thinking, Fast and Slow, Daniel Kahneman says that, “The confidence that individuals have in their beliefs depends mostly on the quality of the story they can tell about what they see, even if they see little.” In his experiments, Kahneman has proved that most people prefer stories and intuition over facts and data.

This, in fact, is how people accomplish memory feats like reciting thousands of digits of pi. No one can remember all those numbers, but they can remember stories. They build mental images, and associate numbers with stories, as they walk through those landscapes in their mind.

In short, a story is a potent tool. And the more sensational the story, the better. Data is hard, but stories are easy.

In reading Burry’s warning about index funds, I’m not sure most readers would follow his logic. After all, it’s a complicated topic and most people don’t have ready access to the same data. But his image of the stampede at the movie theater? Everyone can understand that. Indeed, that’s why I think his comments got so much attention.

Stories aren’t necessarily all bad. But as an investor, it’s important to discern fact from fairy tale. Here are some tips:

1. Determine if the story is even true. Especially today, with the ability to manipulate images and even video, your first step should be factchecking everything you hear.
2. Even if the story is true, ask yourself whether it’s conclusive or just one data point. Anyone who has ever taken a statistics class knows that there are always outliers. Make sure that the narrative you’re hearing isn’t the dramatic story of one extremely unlikely case.
3. If the narrative involves a forecast, ask yourself whether there are alternative narratives that also fit the same facts. That’s what I recommend in the case of Burry’s warning. I’m confident that his opinion is based on facts, but I also think those same facts could lead to a different conclusion.
4. Beware of recency bias. Our minds are programmed to extrapolate. If the market has been going up in recent days, we’re more likely to believe that it will continue, and vice versa. Beware of stories that seem to fit neatly into current trends.
5. Ignore credentials. By its own admission, even the Nobel committee isn’t perfect. Remember Ted Kaczynski? He has a diploma from Harvard. Don’t accept everything people say just because they seem smart or sound good.
6. Diversify. Suppose Burry is right. I don’t think he is, but no one can say with 100% certainty that he’s wrong. Fortunately, there’s an easy solution: diversification. If you own cash and bonds, they’ll help you weather any stock market disruption. In fact, regardless of Burry’s warning, I’d always recommend diversifying like this.

Adam M. Grossman’s previous articles include Adding Value, Three Risks and Room to Disagree. Adam is the founder of Mayport Wealth Management, a fixed-fee financial planning firm in Boston. He’s an advocate of evidence-based investing and is on a mission to lower the cost of investment advice for consumers. Follow Adam on Twitter @AdamMGrossman.

Do you enjoy HumbleDollar? Please support our work with a donation. Want to receive daily email alerts about new articles? Click here. How about getting our newsletter? Sign up now.