The Looming Index Fund Bubble: Why Passive Investing Could Be the Next Big Risk (and How to Protect Yourself)

The Rise of the Index Fund Bubble

Over the last decade, trillions of dollars have poured into index funds and ETFs. These vehicles, designed to track the S&P 500 and other major indexes, have become the go-to investment for millions of investors who want a “set it and forget it” strategy.

At first glance, this looks like a good thing. People are saving, they’re investing, and they’re diversifying. But underneath the surface, something dangerous is happening. Index funds don’t pick companies based on fundamentals. They buy everything in the index—whether or not the businesses are strong, profitable, or even worth owning.

This distortion has led to a breakdown in price discovery—the natural process of the market determining what a company is truly worth based on earnings, growth prospects, and risk. Instead of investors carefully weighing value, billions of dollars flow blindly into the biggest companies simply because they’re part of the index.

As Michael Burry, the investor who predicted the 2008 housing collapse, warned:

“Passive investing has removed price discovery from equity markets.”

And that warning matters more today than ever.

Valuations Detached from Reality

Here’s the uncomfortable truth: stock prices are increasingly disconnected from business performance. A great way to see this is by looking at the Shiller PE ratio, a Nobel Prize-winning measure of market valuation.

Historically, the S&P 500 trades at around 17 times earnings. In 2025, the Shiller PE is at 38—more than double the long-term average. Put another way, investors today are essentially waiting 38 years to get their money back from S&P 500 earnings.

Meanwhile, the market’s earnings yield—the equivalent of an interest rate on stocks—is just 2.6%. Compare that with a 4.5% yield on U.S. Treasury bonds, and you can see the disconnect. Why would anyone accept less return for far more risk?

This reminds me of the late 1990s, when companies like Yahoo traded at sky-high valuations totally disconnected from reality. Back then, the bubble eventually burst. And bubbles don’t deflate quietly—they pop.

How ETFs Could Accelerate the Crash

The problem with index funds isn’t just valuations. It’s also how they function. By design, ETFs must buy when the index rises and must sell when the index falls. That means when the market starts sliding, ETFs will automatically dump shares—accelerating the decline.

Add in human behavior and it gets worse. When markets soar, euphoria pushes prices higher. When fear takes hold, panic selling spreads quickly. With 80% of the stock market now in the hands of institutional investors and funds, any rush to the exits can cause a chain reaction.

Think of it like a crowded theater. The first few people who smell smoke run for the door. The rest see the panic and follow. That’s how automated ETF selling can turn a market correction into a freefall.

The Baby Boomer Selling Wave

Another factor few people are talking about is the demographic shift happening right now. Roughly 75 million baby boomers, who fueled the rise of index funds by investing for retirement, are now moving into retirement and will soon become net sellers.

Unlike younger investors, boomers can’t afford to “wait it out.” A market downturn will force many to sell to preserve what they have. And when boomers panic sell, ETFs have no choice but to sell right along with them. That creates the potential for a devastating downward spiral.

The Concentration Problem in the S&P 500

Even more concerning, today’s S&P 500 isn’t as diversified as it looks. The top 10 companies—the “Magnificent 7” plus a few others—make up nearly 40% of the entire index.

That means almost half of every dollar invested in the S&P 500 goes into a handful of mega-cap companies like Apple, Microsoft, Nvidia, Amazon, and Meta. If even one or two stumble, the ripple effects could drag down the entire market.

The Rule #1 Solution

So what can you do to protect yourself? This is where Rule #1 investing shines.

Instead of blindly buying the market, Rule #1 investors do what Warren Buffett has done for over 70 years:

• Look for wonderful companies you understand.

• Make sure they have a wide moat protecting their business.

• Confirm they are run by honest, capable management.

• Wait patiently until the stock price falls to give you a margin of safety.

When you invest this way, you don’t have to worry about whether the market is in a bubble. You can sit calmly on cash—like Buffett, who’s holding over $340 billion in short-term bonds right now—waiting for great businesses to go on sale.

When the index fund bubble bursts, most investors will panic. But if you’ve done your homework and prepared your shopping list, you’ll be walking in with confidence, ready to buy wonderful businesses at bargain prices.

When an ETF bubble bursts, we’re not running for the exit. We’re walking in with a shopping list.

That’s the power of Rule #1 investing.

Final Thoughts

We don’t know exactly when this bubble will burst. But we do know that buying overvalued indexes, without considering fundamentals, is a recipe for trouble.

The good news? You don’t have to play that game. By learning to invest the Rule #1 way, you can build real wealth safely, patiently, and wisely—without being at the mercy of bubbles and crashes.

If you’re ready to take control of your financial future, I’d love to teach you how. Join me at my next Rule #1 Investing Workshop, where we’ll dive deep into everything you need to know to invest like Warren Buffett and Charlie Munger.

Because when the market falls—and it will—those who know what they’re doing won’t panic. They’ll prosper.