From Cash Cow to Broken Clock

In a world where the allure of wealth and the stock market was an enduring passion, two young boys embarked on journeys that would forever alter the landscape of financial history. Their stories unfold in different eras and places, but they are inextricably linked by a single, enigmatic entity – an unassailable index.

The First Prodigy: 1929

It all began in the tumultuous year of 1929, a time when fortunes were made and lost with the stroke of a pen. Amidst the chaos, a visionary forecaster, made a grievous misstep that shattered his investment advisory service. Driven by an unrelenting desire to understand what had gone awry, he delved deep into the world of forecasting. He meticulously examined the works of other forecasters, and in a moment of enlightenment, penned a story about the index that had defied his predictions. This index humbled him, serving as the catalyst for his subsequent studies on the shortcomings of forecasters and their inability to foresee the future.

Fortuitously, he found himself amid a cadre of leading economists who provided him with an economic research platform. His stories began to captivate the masses, disseminating like wildfire across the globe. Decades passed, a new generation matured, and a future Nobel laureate breathed life into the narrative once more. This story, of an indomitable index and its invincibility, transcended two generations.

The Torchbearer of the Third Generation: A Quest for Unveiling

Fast forward to the third generation, where the fervor for the stock market and amassing wealth remained undiminished. A young, impressionable boy, captivated by the stories of those who had gone before, embarked on a journey of his own. The Nobel laureate's work provided the spark for his audacious dream - to establish an index fund. With unwavering determination, he unveiled this fund to the world.

Three decades passed, and his name echoed across continents. His index fund had grown into a financial behemoth, attracting trillions of dollars in investments and millions of eager investors. Any investment alternative was considered a mere deviation from the index that would revert back to the undeniable truth of the Index. To him, the index was the unerring sun around which the financial world orbited, a gravitational force that defied all other strategies and investment ideas.

A Challenger Rises: Unveiling the Veil of Invincibility

Centuries later, on the distant shores of Asia, a boy emerged from an environment steeped in science and inquiry. Raised by a mathematician mother and an architect father, he fostered a deep-seated curiosity about the workings of the universe. A twist of fate led him into the world of finance and investing, and what he found perplexed him.

The benchmark, often deemed invincible, captivated his attention. The boy embarked on a 30-year journey, studying everyone from Jules Regnault to Einstein, Bachelier to Samuelson, Cantor to Mandelbrot, Turing to Shanon, Galton to Pareto, Boulding to Fama, Pareto to Simon, Rae to Kahneman, Lamprecht to Schumpeter, Jevons to Kuznet, Malthus to Keynes, Aristotle to Fisher, to everything he could lay his hands on. He was relentless in his quest to decode the market's inner workings and the imperviousness of the index.

One fateful day, serendipity intervened, revealing a forgotten detail that had eluded scholars for a century. The birth of modern indexing was intertwined with the work of a long-forgotten German, who, ironically, had little faith in mathematical logic. His equation, however, laid the groundwork for index construction. Yet, there was a hidden flaw, a butterfly flapping its wings ready to unleash a tempest in the investment world.

The flaw, obscured by the euphoria surrounding the index's newfound popularity, lay in the inflation bias. Price increases systematically inflated the index's value, a detail often overlooked. This oversight, like a silent tremor, cast a shadow over the index's invincibility. When a city is built upon a foundation tainted by bias, the distortion permeates every facet of its structure, sowing the seeds of a future cataclysm.

Unmasking the Illusion of Leadership

The veil over the index's invincibility began to lift. This concentration where a few stocks owned most of the Index was the byproduct of the inflation bias, created an illusion of leadership. In truth, it was a façade crafted by a handful of stocks while the majority of the market languished. The concentrated index was a broken clock, seemingly accurate twice a day, perpetuating a mirage of consistency.

Comparing every investment alternative to a concentrated benchmark, is a fate that lacked scientific basis. The index was not the sun, and no methodology could function in isolation and an index weighted heavily will, by its own unsustainable weight, revert to a lower value. All systems, over time, reverted and failed to revert, including the flawed index, which was not above statistical laws.

The Need for Questioning Assumptions: A Paradigm Shift

The narrative of investing could no longer rely on a flimsy foundation. A revelation shook the investment world to its core, highlighting the consequence of building without rigorous questioning. It was a wake-up call for an industry catering to billions, urging them to revisit their preconceptions.

The story is a poignant reminder that the allure of a cash cow can be fleeting if it shuns innovation. These giants, so slow to adapt, exhaust their resources, entrapped by their own inertia and the illusion of invulnerability. They must evolve, else they face obsolescence.

As the index fund company thrived, it held within its clutches a ticking time bomb. The passage of time would ultimately reveal the truth - that the index was not infallible, and the future belonged to those who dared to question, innovate, and adapt. Science demanded scrutiny, logic, and the courage to challenge the status quo.

In the end, the tale of the unbeatable index teaches us that even the most revered and popular beliefs may hold hidden flaws. And it is in the pursuit of truth, through questioning and exploration, that a brighter, more dynamic future emerges.

Notes

"Mr. Cowles was one of the donors of the memorial to his father established at Yale in 1928 as the Alfred Cowles Foundation for the study of government. Alfred Cowles was an investment counsellor in Colarado springs. He told me in 1952 that after the stock market crash of 1929, he realized that he did not understand the workings of the economy, and so in 1931 he stopped publishing his market advisory letter, and began research on stock market forecasting. Harold T. Davis a mathematician who spent summers in Colarado springs, put him in touch with Irving Fisher in Yale, president of the Econometric society. Fisher had known Cowles’ father and uncle when all three were undergraduates at Yale. Davis and Fisher proposed and economics research organization and journal. The idea appealed to Cowles, and he agreed to provide financing. The Cowles commission was founded in Colorado Springs in 1932, and Econometrica began publishing in 1933. Cowles dreamed of predicting the stock markets."

C. Christ, 1994

"My senior thesis at Princeton University in 1951 (mutual funds "may make no claim to superiority over the market averages”. Nobel laureate economist Paul Samuelson played a major role in precipitating the index fund's creation. While I'd hinted at the idea of an index fund in my senior thesis at Princeton University in 1951 (mutual funds "may make no claim to superiority over the market averages"), Samuelson was much more forceful, strengthening my backbone for the hard task that lay ahead: taking on the industry establishment.

His article "Challenge to Judgment" caught me at the perfect moment. Published in the inaugural edition of the Journal of Portfolio Management in the autumn of 1974, it pleaded "that some large foundation set up an in-house portfolio that tracks the S&P 500 Index—if only for the purpose of setting up a naïve model against which their in- house gunslingers can measure their prowess."

Presented with that challenge, I couldn't resist. While all of our peers had the opportunity to create the first index fund, Vanguard alone had the motivation. The newly formed Vanguard Group (owned not by outsiders but by its own shareholders), I reasoned, ought to be "in the vanguard" of this new concept. Our goal was to offer well- diversified funds at minimal costs, focused on the long term."

John C. Bogle - The Professor, the Student, and the Index Fund

John C. Bogle regards mean reversion (or RTM, reversion to the mean, as he calls it) as an important factor affecting all investments. In a 2002 presentation entitled The Telltale Chart (with an updated version included in his 2010 book, Don't Count On It!), he states that RTM is widespread and "can help us to understand financial markets and thereby become more successful investors." (He does not explicitly define the term in that presentation, and it is not perfectly whether he regards RTM as an active compensatory process, or a mere failure of persistence).

Bogleheads, Wiki

History

1871 - Laspeyres Index [The German]

1922 - Irving Fisher, The Making of Index Numbers

1929 - Great Depression

1932 - Alfred Cowles at Colorado Springs

1933 - Cowles’ Foundation

1933 - Alfred Cowles, Can Stock Market Forecasters Forecast?

1950 - Most popular Index - S&P 500

1951 - John C. Bogle's - Senior Thesis

1974 - Paul Samuelson's - Challenge to Judgement

1976 - Launch of Index Fund

Bibliography