Mark Perry makes the (updated) case for index funds. I need no convincing, as most** of my savings (such that they are) are in Vanguard index funds of various sorts.
But as I was reading his article, I couldn't help thinking that there is a flaw with the "everyone should be in index funds" advice -- if everyone actually was 100% in index funds, they would not work. Index funds are premised on the idea that stock prices are pretty well reflective of the information out there in the marketplace -- the company's future prospects, the strength of its market position, the direction of external factors such as economic growth and interest rates, etc. But this is only going to be true if there are investors out there trying to pick stocks and beat the market -- ie if everyone is not in index funds.
It sort of reminds me of the old economics joke where a man is walking down the street with an economist, and the economist walks right past a $20 bill lying on the ground. The man says to the economist -- "do you realize you just walked past a $20 bill?" and the economist answered, "It couldn't really be there -- in an efficient market, someone would have already picked it up."
In some ways, the stock pricing paradox here is just an example of a larger phenomena which for the lack of a better name I call "the joy of shopping." People make fun of shopping all the time, but economically shopping is really a miracle. All the things we attribute to prices and efficient markets and competition and the accountability of markets depend on shopping. Individuals have to be out there making price-value trade-offs between products, or between buying something and not buying something. For example, at least half of everything wrong with health care economics can be explained by lack of shopping.
The interesting thing is that only a small percentage of consumers in any particular market have to be hard-core shoppers (meaning they do tons of research and compare prices across multiple sellers) for all of us to benefit. I seldom look at a price in Wal-Mart because I know other people who care a lot have enforced a discipline on Wal-Mart. Just as with my Vanguard mutual funds, I depend on that core of folks who walks the aisles of Wal-Mart checking every price against Amazon and Target.
** I do enjoy picking stocks, and have a particular affinity for shorting things too early. I never, ever let this portfolio grow to more than 5% of my total savings, and treat it explicitly as a sandbox to play in rather than real investments on which my future well-being depends.