Earlier this week, an investment manager named Michael Burry made waves when he issued an apocalyptic forecast: Index funds, he said, are in a bubble similar to the housing bubble that ended very badly in 2008. Burry couldn’t say when that crash will happen but noted ominously: “The longer it goes on, the worse the crash will be.”
Burry acknowledged that he is “100% focused on stock picking,” so at first glance, his criticism seems not unlike other active fund managers’ criticisms of index funds. Competitors have been lobbing grenades at indexing since its inception nearly fifty years ago when one active manager called index funds “un-American.”
But Burry isn’t just any ordinary stock-picker. He is a sort of cult hero within financial circles. A neurologist by training, Burry left medicine to start a hedge fund and was one of a small handful of investors to predict the 2008 crash in mortgage bonds, and to profit from it. In The Big Short, his book on the topic, Michael Lewis cast Burry as a central character. In short, Burry is exceptionally talented with a track record that speaks for itself. So this week, when he issued his broadside against index funds, people listened.
In Burry’s view, the growth of index funds presents several dangers. First, they use derivatives, “the same fundamental concept that resulted in the market meltdowns in 2008.” And, he cautioned that index funds could face a liquidity crunch. “The theater keeps getting more crowded,” he said, “but the exit door is the same as it always was.”
That last line was the one that really got people. No one likes the idea of being stuck, especially when it comes to one’s finances. And no one likes the idea of getting caught in a stampede.
While I disagree with Burry’s doomsday forecast, I’d like to discuss a broader issue here. My peers Allan Roth and Ben Carlson have done, I think, the best job responding to Burry’s comments point by point. Vanguard also addresses some of Burry’s criticisms in this paper. I recommend reading what they have to say. I’m also happy to answer questions and address your specific concerns. Please call any time.
The broader issue, in my view, is our propensity as human beings to buy into narratives like Burry’s. As Jonathan Gottschall wrote in The Storytelling Animal, “We are, as a species, addicted to story. Even when the body goes to sleep, the mind stays awake all night, telling itself stories.” And writing in Thinking, Fast and Slow, Daniel Kahneman says that, “The confidence that individuals have in their beliefs depends mostly on the quality of the story they can tell about what they see, even if they see little.” In his experiments, Kahneman has proved that most people prefer stories and intuition over facts and data.
This, in fact, is how people accomplish memory feats like reciting thousands of digits of pi. No one can remember all those numbers, but they can remember stories. So they build mental images and associate numbers with stories as they walk through those landscapes in their mind.
In short, story is a potent tool. And the more sensational the story, the better. Data is hard, but stories are easy.
In reading Burry’s warning about index funds, I’m not sure most readers would follow his logic. After all, it’s a complicated topic, and most people don’t have ready access to the same data. But his image of the stampede at the movie theater—everyone can understand that. That’s why, I think, his comments got so much attention.
Stories aren’t necessarily all bad—but as an investor, it’s important to discern between fact and fairy tale. Here are some tips:
1. Determine if the story is even true. Especially today, with the ability to manipulate images and even video, your first step should be to fact-check everything you hear.
2. Even if the story is true, ask yourself whether it is conclusive or just one data point. Anyone who has ever taken a statistics class knows that there are always outliers. Make sure that the narrative you’re hearing isn’t the dramatic story of one extremely unlikely case.
3. If the narrative involves a forecast, ask yourself whether there are alternative narratives that might also fit the same facts. That’s what I recommend in the case of Burry’s warning. I’m confident that his opinion is based in fact, but I also think those same facts could lead to a different outcome.
4. Beware of recency bias. Our minds are programmed to extrapolate. If the market has been going up in recent days, we’re more likely to believe that it will continue, and vice versa. So beware of stories that seem to fit neatly into current trends.
5. Ignore credentials. By its own admission, the Nobel committee isn’t perfect. And Ted Kaczynski has a diploma from Harvard. So don’t accept everything people say just because they seem smart or sound good.
6. Diversify. Suppose Burry is right. I don’t think he is, but no one can say with 100% absolute certainty that he’s wrong. Fortunately, there is an easy and free solution: diversification. If you have sufficient assets in cash or bonds, that will help you weather any stock market disruptions. Regardless of Burry’s warning, I would always recommend this.