As Markets Become More Passive, Volatility Amplifies, And Markets Become More Unstable

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During his recent interview with Tobias, Chris Cole of Artemis provides some great insights into the impact that passive investing has on market volatility and market instability, saying:

Let’s imagine that we go out and I get incredibly drunk. I get crazy drunk, and I am a passive investor. I’m wandering around aimlessly in whatever direction. But you are my friend and you’re an active manager. Your job is to direct me home. So when I go too far to the left, you bring me back. When I go too far to the right, you bring me back. You’re helping me get home even though I’m a stumbling drunk.

Well this is what active investors do. When things become too undervalued they buy. When they become too overvalued, they sell. They’re ‘volatility stabilizers’ and they’re helping to find value in markets. The same way that a sober man is helping to get a drunk man home along an optimum path. This works out wonderfully and you are compensated for your efforts.

Now let’s imagine an alternate situation happens. The passive drunk becomes so dominant, so large, that all of a sudden… I’m not 5’10”, 180… I am now 20 feet tall and I weigh 500 pounds. I am a giant and I am drunk out of my mind and you are trying to pull me back to the right path but you can’t. I’m too big. I’m too strong. I’m stumbling drunk but you can’t correct it.

This is what happens when passive investors dominate the marketplace. They are a large stumbling drunk that’s just going to roll in whatever direction and the active managers become too inconsequential to correct their valuations. So in either direction, depending on the prevailing mood of the economy, you’re either gonna have wild fluctuations to the upside or you’re gonna have wild fluctuations to the downside. Whatever the prevailing dominant dynamic is.

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