Why the Stock Market Might Be Broken

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The Tale of Index Funds: A 50-Year Bet on Simplicity

If you’ve ever thought about investing your money, you’ve probably been bombarded with advice about where to put it. Books, articles, podcasts, and maybe even your high school economics teacher will often suggest one simple path: invest in an index fund. They’ll say, “It’s the easiest, safest way to build wealth for 99% of people.” And today, that idea dominates the market. But what if I told you that this popular advice is built on a theory that might be outdated by 50 years, and its logic could be off—way off.

Let me take you back to the start.

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A Revolutionary Idea

The year is 1976. The investment world is a far cry from what we know today. Hedge fund managers and stock pickers are the kings of Wall Street, making their living by charging high fees and promising to beat the market with their "expertise." Meanwhile, over at a company called Vanguard, a man named Jack Bogle is quietly working on something that sounds crazy. He’s launching a fund not designed to beat the market but to be the market.

Bogle’s big idea is simple: most investors can't consistently outperform the market, so instead of trying to outguess everyone else, just own everything. He creates a fund that buys all the stocks in the S&P 500, and lets them ride. This was the birth of the first index fund—a way to track the market’s overall performance instead of trying to beat it.

At the time, no one took Bogle seriously. The first time his fund IPO’d, it raised a laughable $11 million, far short of its $150 million goal. Critics called it "un-American," arguing that blindly following the market was no way to get rich. And in an industry where everyone was touting their ability to make you rich by being smarter than everyone else, Bogle’s idea seemed foolish.

But what started as a contrarian move slowly began to gain traction.

The Efficient Market Hypothesis

To understand why Bogle believed in his index fund, you need to understand the theory behind it. It’s called the Efficient Market Hypothesis (EMH), and it’s basically a theory that says prices in the stock market already reflect all available information. In other words, no matter how much you analyze, research, or guess, you can't consistently beat the market because all the relevant data is already "baked in."

Imagine you're at an auction. There’s a box being sold, but you don’t know what’s inside. Someone guesses it’s an elephant because they can see a tail poking out. They bid $500. Then someone else says, “Wait, it might be a tree—look at the leaves.” They lower their bid to $300. Each new piece of information changes the value of what’s in the box. The price is always adjusting based on the latest knowledge.

The EMH tells us that the stock market works the same way: prices move in real-time based on all available data. And since it’s impossible to predict the future or know more than everyone else, the most rational move is to own the entire market and wait.

Fast Forward: The Rise of Index Funds

Over time, Bogle’s simple approach started to pay off. In the decades that followed, study after study showed that most active fund managers—the ones who charge hefty fees for trying to beat the market—*couldn't*. According to a 2020 analysis, 89% of all actively managed funds underperformed the S&P 500 over a 15-year period. It turned out that Bogle’s passive approach was not only simpler, but more profitable.

As more investors caught on, trillions of dollars began flowing into index funds. Vanguard, once mocked for its seemingly naive idea, became a financial behemoth. The numbers were hard to argue with: index funds charged lower fees, provided market-average returns (which were often better than actively managed funds), and over long periods, the market seemed to go up. In fact, from 1980 to 2023, the percentage of Americans holding stocks soared from 13% to 61%, largely thanks to the rise of index funds.

But here's where the story takes a twist.

A New Problem

As index funds became the default investment vehicle for millions of people, something strange started happening. The sheer volume of money flowing into these funds began to impact the very markets they were designed to follow. Instead of being neutral observers, index funds started becoming the market itself. And as the market surged, some began to wonder: were index funds inflating stock prices?

Economists like Xavier Gabaix proposed a new theory called the Inelastic Market Hypothesis. This theory challenges the EMH by suggesting that the market isn’t as efficient as we thought. In fact, every dollar that flows into the stock market via index funds doesn’t just increase the value of the stock by a dollar—it increases it by five. According to Gabaix, passive investing is inflating stock prices far more than anyone realized.

The Risk of a Bubble

If Gabaix is right, we could be heading toward a massive market correction. With trillions of dollars passively flowing into the market, stock prices may no longer reflect the actual value of companies. Instead, they reflect the growing popularity of index funds. And if investors start pulling their money out, the market could tumble faster than we expect.

In a world where index funds dominate, the risk isn’t just that stocks are overvalued. It’s that we’ve created a market where the majority of investors aren’t even trying to value stocks accurately—they’re just following the herd. And when that herd changes direction, the consequences could be swift and severe.

Where Does That Leave Us?

Here’s the dilemma: index funds have been a reliable way to grow wealth for decades, but their very success might now be distorting the market. Should you still invest in them? Most experts say yes. Vanguard and other major players argue that the vast majority of stock market activity still comes from active investors, and that index funds aren’t destabilizing the market—at least, not yet.

But as with any investment, there’s no such thing as a sure bet. The stock market has always been a game of risk and reward, and the rise of index funds hasn’t changed that fundamental truth. The market might only go up in the long run, but as we’ve learned before, it can also crash unexpectedly.

The moral of the story? Stay informed, stay curious, and never stop questioning the narrative. Fifty years ago, the idea of index funds seemed like a joke. Today, they rule the market. But as with everything in life, what goes up may eventually come down—and the more we understand why, the better prepared we’ll be.

In the end, the only constant is change. And in investing, as in life, the best returns come from those who are patient enough to stay in the game, but wise enough to see the risks ahead.