You Only Want the Good Stocks in the Index

You can think of index investing as an algorithm that says that the stocks with the highest prices today will be worth the most in the future. So you take your money and bet a lot of it on the stocks that are worth a lot now, and less of it on the stocks that are worth less now, and (with all but the broadest indexes) none of it on the stocks that are worth only a little bit now. This is a pretty good strategy—not perfect, but better than a lot of other strategies—because markets are mostly pretty efficient and today’s price mostly is a pretty good predictor of tomorrow’s.

Not perfect. If you only invest in the companies that are worth a lot now, you will miss out on the brilliant disruptive innovators that are just starting out. And if you invest in all the companies that are worth a lot now, you will occasionally put money into silly overvalued bubbles and frauds. This is not all that strong an argument against indexing: Those bubbles and frauds got inflated because somebody else, some active investor who was picking stocks, overvalued them. Index investors are not uniquely susceptible to bubbles; if they were, there’d never be bubbles.