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The stock market is a market just like any other market you can think of, only the stock market is a marketplace where stocks of companies are traded and not physical commodities like rice, coffee, or gold. There is a popular passive investing strategy that has been steadily gaining traction since its inception in the 1970â€™s which is called â€œindexingâ€. Indexing is where you attempt to replicate the overall performance of a stock market index, such as the S#038;P 500 index, which is a market capitalization weighted index comprised of the largest 500 stocks proportional to their market capitalizations. Market capitalization weighting works like this. If Appleâ€™s overall stock value of its available shares represents 10% of the overall value of all the stocks in the S#038;P 500, then the weight given to Apple will be 10% in the index. So if you buy a single share of an index fund that tracks the S#038;P 500, then 10% of your investment is devoted to Apple stock.
The reason I am talking about this is because part of macroeconomics is to distinguish between the aggregate and the micro, or the difference between open and closed systems. For exle, lets imagine a hypothetical situation where the 500 stocks comprising the S#038;P 500 were the only stocks you could buy or sell. In this hypothetical situation every market participant each has a thousand dollars to invest. The overall market performance of 500 stocks is a closed system, whereas the actions or performance of individuals is an open system. Letâ€™s say that over a yearsâ€™ time the value of the S#038;P 500 index goes up by 15%. An individual could take a selective position and buy a select number of stocks and have the remarkable performance of a return over the same yearsâ€™ time. However, by mathematical definition not every person participating in the market can have a return, in fact the returns for each individual is a zero-sum game. This means that for every person that does better than the 15% average return, there is another person that does worse than 15%. In fact, the 15% return of the S#038;P 500 is only a weighted average return of all the market participants, which means that if you were to add up every market participantsâ€™ return and divide it by the number of participants it would come to 15%.
So indexing takes advantage of this mathematical truism by attempting to become the market return. Indexing strategists realize that it is very difficult to know ahead of time which stocks are going to perform better than the overall market. In fact, even attempting to beat the market entails significant costs such as research, transaction fees, and labor costs. And there is no guarantee that you will beat the market, rather you could actually underperform the market as mentioned earlier.
Watch the following PBS Frontline video on the financial industry and their involvement in the 401(k) retirement system:
http://www.pbs.org/wgbh/frontline/film/retirement-gamble/ (Links to an external site.)
Write two paragraphs on the following questions:
- The financial industry is able to hire vast amounts of highly educated workers from elite universities. In fact, large numbers of these new graduates are from engineering, physics, and science backgrounds. How do you think productivity, technological innovation, and GDP are affected by the fact that the financial industry is able to lure these highly skilled graduates into the financial industry?
- Due to the exorbitant fees hidden in mutual funds, many retirees will not be able to keep the same standard of living that they were accustomed to in retirement. How do you feel this will affect GDP and governmental expenditures once people start retiring and living off their savings from their 401 (k).
Side note: I think that this PBS Frontline video is an invaluable documentary that will benefit you tremendously when planning for your own retirement. After watching it please do yourself a favor by doing some additional research by looking into the issues detailed in the piece when planning for your retirement.
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