There are valid reasons to take a different approach.
A False Assumption
Friday's column pointed out that, contrary to common belief, investors aren't necessarily being theoretically correct if they index the entire stock market. As Dr. Harry Markowitz pointed out, some years back, the postulate that rational investors should own all equities, in proportion to their stock-market worth, relies on the assumption that stock owners will routinely leverage at the risk-free rate. As that is not the case, the theory collapses. There may be valid grounds to own something other than the market portfolio.
(Of course, most investors, behaving as butterfly collectors rather than as engineers, own something other than the market portfolio. But those differences owe to accidental decisions. This column, instead, concerns the intentional reasons that one might digress from orthodoxy.)
This finding comes, indirectly, from Markowitz's paper. Markowitz shows that if leverage is not easily affordable and common, then aggressive investors will deviate from the market portfolio. Per the very logic that recommends the market portfolio--that is, the capital asset pricing model (CAPM)--the higher a stock's beta, the higher its expected returns. Without the use of leverage as a tool, the aggressive buyers will crowd into high-beta stocks.
This behavior could create pricing distortions--that is, make stock prices inefficient. (Markowitz's paper doesn't raise that possibility, but others have.) If too much money chases the same subgroup of high-beta stocks, then those securities may become overbought, and thus deliver weaker-than-expected future returns. Then, as the news of that failure becomes known, investors might flee high-beta stocks, knocking down their prices so that they become bargains.
Perceiving these effects and profiting from them are difficult tasks, to be sure. However, the point remains: Because the stock market does not obey one of CAPM's key assumptions, it may have systematic pricing distortions. That represents an opportunity for active investment managers.
There may be other openings, too. Although (to my knowledge) the interplay between high- and low-beta stocks is the only potential consequence that is suggested by the CAPM, other things could also cause knock-on effects. For example, many observers argue that inflows into index funds have distorted stock prices, boosting shares that are held by the popular indexes and leaving other shares to languish. I disagree, but there's no doubt that such a thing could occur.
Varying Definitions of Risk
The remaining three arguments against owning the stock market portfolio do not involve claims of mispricing. Rather, they reflect differences in personal situations--individual circumstances that can lead two fully rational investors to hold different stock portfolios.
One obvious example is dissimilar needs for liquidity. An investment manager who runs a mutual fund that has few shareholders, with each shareholder commanding a high percentage of fund assets, faces the daily possibility of being forced to sell a big chunk of assets to meet a sudden redemption. Holding stocks that may be traded easily becomes important. In contrast, the investment manager of a closed-end fund faces no such danger.