I’d like to think Shiller is wrong, but that idea makes me nervous. You say that: “when an index fund is purchased its price will necessarily change relative to the underlying basket of assets. If the price of the index rises above the asset value of the underlying basket then a market maker will sell the index and buy the underlying basket.” I think the question that many people have (including me) is how much of the market has to be actively making this comparison in order for the prices to not get too wacky. For example, if only 20% of the market is exploiting these value differentials (the pyramid is inverted), is that enough to avoid prices getting crazy high and then crashing? I think that’s the “chaotic system” that Shiller is referring to. (Note, I realize 20% active is not the current situation. I am pushing the example to an extreme to make my point.) Given that Shiller says markets are often irrational, and relatively passive investors ignore rationality (at least when it comes to pricing), isn’t there a potential hazard with the relatively passive approach when it becomes a substantial part of the market?
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