Times have certainly changed. A couple of years ago, when the market was skyrocketing and investors seemingly couldn't go wrong, it was often argued that stock-picking was for chumps--after all, why throw away a percent or two of savings growth a year on managers' fees, or gamble everything on an insufficiently broad portfolio, when an index fund virtually guarantees near-double-digit returns over the long term? Well, now that the market's tanking, Daniel Gross is singing a different tune in Slate, criticizing the S&P 500 index for, of all things, being lousy at picking stocks--adding companies to the index just as their share prices peak, and then keeping them on the roster as they collapse.
The charge is, of course, utterly absurd; the S&P 500 is supposed to track the large-cap market, not beat it, and if investors are pumping up dubious tech stocks to absurd valuations, then it's not S&P's place to second-guess their judgment. Moreover, the index investing dogma of the nineties asserted adamantly that such fluctuations shouldn't matter anyway to the long-term buy-and-hold investor, who could look forward to excellent returns by explicitly not timing the market, buying instead at a constant rate ("dollar-cost averaging") year in and year out, and counting on the market's historically reliable high return rate to do its work.
The flaw in this strategy--as we have now all been so painfully reminded--lies in its assumption that stocks' consistently higher return rates are a blessing that simply drops out of the sky into the laps of delighted passive investors. In fact, their true source is the vigilantly skeptical discipline of history's (overwhelmingly active, portfolio-managing) investors, who have made a practice of avoiding stocks whose high prices precluded a sufficient return on their invested purchase price. By refusing to overpay, those finicky investors kept stock prices (relative to earnings) down, and thus returns (per dollar invested) high.
Passive (or uninformed) investors, on the other hand, show no such discipline; they robotically pour their money into index (or, for that matter, actively managed all-stock) funds, regardless of current share prices or prospective corporate earnings. And as their numbers increase, they can exert a significant influence on those share prices, lifting them to the point where the potential earnings (again, per dollar invested) of the companies they represent pale in comparison with the earning power of, say, Treasury bills.
Eventually, of course, sharp-eyed investors begin to notice that they're being fleeced and head for the exits, bursting the bubble and stranding the remaining shareholders with stock worth a tiny fraction of its grotesquely overinflated purchase price. That's exactly what happened to most of the millions of American investors who collectively lost trillions of dollars in the market over the last several years. By comparison, the effects of badly-timed additions to or deletions from the S&P 500 index are a piddling, deck-chairs-on-the-Titanic irrelevancy.