Long read: What Passive Investing Has Done To Our Retirement

He gives ten illustrations of the law – we reproduce one that relates to the piece on IIT’s above –“Standardized Testing in Education: Schools judged by test scores often “teach to the test” or even cheat. As a result, real learning declines, and education becomes more about gaming the system than teaching students to think.” 

In the context of this article, the reference to Goodhart law is that “The S&P 500 used to tell us something meaningful about the real economy. Today, it tells us more about the mechanical flow of retirement money than the health of American business.”

It refers to passive funds which deploy money in the S&P500 index stocks blindly:

“Green calls passive investing the “giant mindless robot.”
Why?

Because when new money flows into index funds, it doesn’t sit on the sidelines. This money flow is not completely isolated from the index it tracks. Rather, it buys stocks immediately. And not just any stocks. It allocates the largest share of incremental purchases to the largest stocks (like Apple, Microsoft, Nvidia, and Amazon) because those names dominate the index.

This creates what economists call a “price-insensitive buyer” – the most dangerous type of market participant. The money flows in, the big stocks get bigger, and the index rises. That rise draws in more money, which buys more shares, pushing prices even higher.

It’s momentum on autopilot.

Here’s where Goodhart’s Law reveals the fundamental problem. The index has become the target of trillions of dollars in retirement accounts, pensions, and ETF flows. It’s no longer as good a measure of economic strength as it once was!”

How does it distort the S&P500’s ability to be a barometer of the economy:

“When markets rise, it looks like all is well. But the rise may have nothing to do with rising profits or productivity. It may simply be the result of mechanical buying by investors who have abdicated all responsibility for the deeper thinking that drives price discovery.

Consider the math of this distortion. Passive funds don’t care if stocks are expensive. They buy based on market cap, not fundamentals.

If Apple doubles in price, index funds buy more Apple. If Tesla triples, they buy three times as much Tesla as they did before it triples. Does that make logical sense?

…Green explains that this creates a multiplier effect.

If you gave $1 to an old-school, active mutual fund manager, they might have sat on it, waiting for better stock prices or more favorable economic conditions. The market barely moves because back in the day, when value investing ruled, fund managers were liquidity providers and volatility dampeners. That is, when stocks went on sale, their demand for stocks rose. When stocks reached objectively expensive levels, they sold and raised cash.

But give that same $1 to a passive fund, and it gets deployed immediately into the biggest stocks. The impact that the marginal dollar has on stock prices when it goes to a passive fund is massive – up to 20 times greater than the same dollar going to an active fund, according to Green. A price-insensitive buyer is by definition not fazed by having a 20x impact on the marginal stock price.”

Green gives a real-world analogy to help drive home the point:

“Green asks us to imagine walking into a rug shop where the shopkeeper offers a Persian rug for $1,000.

A normal buyer might hesitate and start to walk away. The shopkeeper then says, “Okay, $500,” which entices the buyer. They perceive it as a bargain and decide to purchase.

Now, imagine how a passive fund would behave in the same scenario. Green explains: “The shopkeeper says, ‘$1,000,’ and they say, ‘Okay, I’ll take it.’ Then he says, ‘No, no $1,500,’ and they say, ‘I’ll take it.’ ‘$2,500?’ ‘I’ll take it.’”

This scene captures the absurdity of passive investing’s price-agnostic behavior. As Green notes, it’s not that passive funds are price insensitive. They’re actually price-responsive in the worst possible way.”

Why should we be worried about this?

“But what happens if the flows stop – or worse, reverse? That’s the nightmare scenario that keeps thinking investors awake at night.”

What is likely to make it stop or reverse?

“One major, related issue is demographics. The math here is unforgiving. Baby Boomers hold most of the wealth in America. But they’re aging. At age 72, they must start withdrawing money from tax-deferred retirement accounts like IRAs. Some of that money gets reinvested. But much of it leaves the market altogether. This creates a steady, growing headwind for passive inflows.

At the same time, younger generations face economic headwinds that didn’t exist for their parents. Entry-level job prospects are weak. Wages are stagnant relative to asset prices. Many aren’t contributing to retirement plans at all. That limits the next generation’s ability to offset the Boomer outflows.

Green also warns in his interview that technological change is eating away at the job market faster than new jobs are being created. That means fewer workers, fewer contributions, and more early retirements – exactly the opposite of what passive investing requires to function.

In this environment, passive outflows are not a remote possibility. They’re a real and growing risk that most investors refuse to acknowledge.”