PF Investing Club: The Stock Market & Compounding Interest

[MarneMath]

Due to my job, I'm not allowed to give much advice regarding this. I will reiterate my position that for most people, picking their own stocks is absurd and for individuals I've seen who have done so their profile typically carries ungodly amount of risk. Are there people who do it right, sure. It isn't common. There are many theories to picking stocks, and the most popular on this forum seems to be the more traditional value based approach. There's nothing wrong with that. I'll say though, that focusing on solely PE, and ignoring the 4 other fundamentals to markets is foolish.

However, if you're goal is simply to beat your saving's account, that's relatively trivial task. Investing to live off your gains is a completely different ball game.

 

[Vanadium 50]

Stephen, it sounds like you are describing arbitrage - the simultaneous buying and selling to take advantage of a differing price. You don't need to go to multiple exchanges to see this: it commonly appears during mergers: if ABC merges with XYZ such that an owner of XYZ gets two shares of ABC, and ABC is trading at 10, you'd expect XYZ to be worth 20. But it might be worth 19.99 or 20.01.

What you will find is that the ratio of the prices of the two stocks is not 2.00 exactly, but moves around in a narrow band. The width of that band is determined by transaction costs and the return you would get on a "safe" investment. If the merger is in a month, to make this worth doing, you have to make more money with all this buying and selling - after transaction costs - than you would by simply buying a 28-day treasury.

What you are describing is a more efficient arbitrage. That tends to reduce transaction costs, and that tends to reduce the width of this band. It doesn't do anything to the underlying value, which is driven by future returns.

I'll say though, that focusing on solely PE, and ignoring the 4 other fundamentals to markets is foolish.

I think one thing which hasn't been addressed as much as it should is that a low P/E may mean that a stock is cheap. Or it may mean that it's on a slide into oblivion.

 

[Stephen Tashi]

Please show me an example of a fund that does this. I want to invest in it!

I don't know of an pure plays on high freqency trading open to public investment. You can invest in large banks, like Goldman-Sachs, which have high frequency trading departments.

Anyway, this suggested approach a) doesn't have anything to do with what we are discussing (that stocks are over-valued and computers will figure that out) and b) represents either a technical flaw or illegal activity.

It does seem an "unfair" activity, but it is not illegal. In fact, the secrecy of the computer codes companies use is protected by laws (https://en.wikipedia.org/wiki/Sergey_Aleynikov). The example only has to do with your remark that high frequency trading doesn't beat the market.

I believe I've read about companies getting in trouble for purposely delaying stock price reporting in order to create and exploit such a discrepancy.

The new IEX stock exchange delays quotes in order to thwart high frequency trading. Real time quotes are what high frequency traders want.

Yes, it is/does:
http://www.investopedia.com/terms/o/overvalued.asp

That says the p/e ratio is the "most popular" method of valuing stocks - not the only method.

Ok...then you seem to be acknowledging what you've been suggesting is wrong?

On the contrary, it would be an example of what I'm suggesting.

No, I have not made that argument. You have been suggesting that the value of companies might, in the aggregate be very wrong and "fixing" that would change the future stock price outlook and make market returns drop. This would have to manifest as the "normal" p/e ratio for stocks going down dramatically and continuously and I'm saying that isn't possible.

Why do you say the "normal" p/e would go down? And why continuously?

Here's what your suggestion would look like:

Currently, say the historical average p/e ratio is 15 and say the computers figure out that that's wrong and it should have always been 12. The market will then drop by 20%, once, and then return to its long-term average growth rate after making that correction.

I don't know whose long term average growth rate you're talking about - the market's or the stock's. Any wiggly curve can be be assign a "long term average" rate of change by computing an average. An over any historical period, the curve "returns" to its average rate because that's how the average rate is computed.

On the other hand, if what you suggest were true - that the long term growth rate could be substantially and permanently reduced - the "right" p/e ratio would have to continuously drop (12 next year, 11 the year after that, etc...), which is a contradiction in your suggested mechanism and can't happen.

If a future stock price could be more accurately predicted, it does not follow that its current market price would drop or that that its current market value would rise. The current market value of an investment with a known future value depends on what people (or computer programs) are willing to tie-up in the investment for a period of time in order to get a larger amount back at a later time.

 

[Stephen Tashi]

Stephen, it sounds like you are describing arbitrage

Yes, but the topic came up as a digression from the topic of the OP [ meaning my OP in the thread] , which wasn't about short term trading.

That tends to reduce transaction costs, and that tends to reduce the width of this band.

I don't know why it would tend to reduce transaction costs - and whose costs are we talking about ? The exchange's? The traders? - and that's yet another digression.

It doesn't do anything to the underlying value, which is driven by future returns.

"Underlying value" is ambiguous concept, but I certainly agree that the value-as-measured-by-current-price-of-a-stock set by an investor does depend on his predictions for that same measure of value in the future.

I think one thing which hasn't been addressed as much as it should is that a low P/E may mean that a stock is cheap. Or it may mean that it's on a slide into oblivion.

And promising start-ups have infinite p/e's !

 

[MarneMath]

I'm not sure what the point of the discussion between Russ and Stephen is really about. Comparing HFT to long term investments is like comparing collecting quarters for the laundry machine vs saving for a mortgage. Yeah your saving money for a task but the time frame and goals are completely different. HFT typically deal in low capital short positions profiting on cents and crowding of markets. HFT have many strategies most if not all strategies have little concern for market value but rather liquidity and over-crowding.

If the discussion is more about how HFT may effect long term value. That's not such an open and shut question. There exist papers regarding how the algorithms may help long term investors, but there are also reasonable papers on how they may negatively effect long term investors. Heck there's even papers on how it has no effect. Point is that it isn't simple to say one way or another.

 

[Stephen Tashi]

I'm not sure what the point of the discussion between Russ and Stephen is really about.

I'm not either!

Comparing HFT to long term investments is like comparing collecting quarters for the laundry machine vs saving for a mortgage.

The point of mentioning HFT was to only raise the additional possibility that (future) computer programs might also dominate long term investing. HFT illustrates the fact that current computer programs do have the ability to deal with stock transactions and are effective over the short time spans they seek to handle.

If the discussion is more about how HFT may effect long term value. That's not such an open and shut question. There exist papers regarding how the algorithms may help long term investors, but there are also reasonable papers on how they may negatively effect long term investors. Heck there's even papers on how it has no effect. Point is that it isn't simple to say one way or another.

I agree, it isn't simple!

 

[MarneMath]

The point of mentioning HFT was to only raise the additional possibility that (future) computer programs might also dominate long term investing. HFT illustrates the fact that current computer programs do have the ability to deal with stock transactions and are effective over the short time spans they seek to handle.

I concur. Betterment basically uses algorithms to buy ETF and automates the risk pool allocations. It isn't a leap to think algorithms can take in earning statements, and market conditions as inputs and make stock selections as well as your common day trader.

 

[Vanadium 50]

Algorithms are nothing new. When Daddy Warbucks would say "Buy it at 8 and sell it at 10!" that's algorithmic trading. A less fictional example is a stop-loss order. An example that people don't usually think of as algorithmic is an index fund: if ABC drops off the index and XYZ replaces it, the fund has to sell ABC and buy XYZ.

 

[Stephen Tashi]

Algorithms are nothing new. When Daddy Warbucks would say "Buy it at 8 and sell it at 10!" that's algorithmic trading. A less fictional example is a stop-loss order. An example that people don't usually think of as algorithmic is an index fund: if ABC drops off the index and XYZ replaces it, the fund has to sell ABC and buy XYZ.

That's correct. What's new is the speed at which algorithms can be executed and the amount of data they can take as inputs. For example, "disciplined" investors who take a long term approach may apply the same series of calculations to the financial statements of each company they analyze. How long does it take a human being to do such work? A human being can probably be competitive with a computer if the scope of the investigation covers only the amount of material that human would examine. But if we extend the scope of the investigation beyond that limit by using algorithms designed by humans on the theme of "These are things I would do if I only had the time and resources" then computer programs have the advantage. (For example, it is claimed that some HFT algorithms can consider breaking news stores - i.e. they analyze text data. So is it a stretch to think that a program trying to do long-term investing could analyze articles written about a company ?)

Human long term investors aren't supposed to "buy and hold" blindly. They are suppose to re-examine their investments periodically to detect fundamental changes. How often do they have time to do this?

I suppose it's possible that increasing the amount of data used to make a prediction about a stock will not increase the reliability of the prediction. That would keep the world of long term investing safe from the invasion of computers.

 

[NTL2009]

...

Human long term investors aren't supposed to "buy and hold" blindly. They are suppose to re-examine their investments periodically to detect fundamental changes. How often do they have time to do this? ...

I think people way overestimate the value of "examine an investment for fundamental changes".

Let's say a company has experienced a "fundamental change" - their market has shrunk, or they are no longer competitive in that market, etc. OK, but that information is available and is already reflected in its stock price. There is nothing you can do about that.

If you sell, the real question is will what you buy do better than the one you just sold from that point forward.

So what you are concerned with is, how will this stock do in the future (compared to the market)? That is not known. They may find a way out of their mess, or re-invent themselves, or get bought out. But we don't have a functioning Crystal Ball, so we can't make a decision based on that. But the market will consider those possibilities, and assign some sort of value to it, and can be right or wrong in aggregate. But none of that really helps us, does it?

I've read some studies that say there is value in buying stocks that are "out of favor", companies that people expect to do badly. Their price has been beaten down, and human nature tends towards "group think", so too many people sell, driving the price lower than fundamentals might indicate. In aggregate, these stocks will exceed their artificially low expectations, and do better than market averages.

If that study holds, the results are counter to what an individual would do on the above advice. They would sell at a low price to dump a stock with poor fundamentals. That might be the worst approach. Or using the reverse Crystal Ball quote from Will Rogers again, "If it don't go up, don't buy it!".

This is why I'm a fan of buying broad based index funds and ignoring them. Works just fine.

 

[russ_watters]

That's correct. What's new is the speed at which algorithms can be executed and the amount of data they can take as inputs.

I'll get back to the other stuff later (I'd still like to know what, if anything, you were really getting at), but I'll put in my agreement with @NTL2009:

Succinctly: It is a myth that managed funds do better than index funds. (this should be added to the financial knowledge thread). They don't. In fact, almost all of them do worse.

http://www.marketwatch.com/story/wh...-funds-beat-the-sp-than-we-thought-2017-04-24

The performance of actively managed funds is so bad that just by luck, you would expect half of them to beat the S&P and 5% basically means they are all bad. So you can essentially say that all managed funds are a bad idea because the only way for them to beat the S&P is by luck.

Applying this fact to the current discussion gives us:

For example, "disciplined" investors who take a long term approach may apply the same series of calculations to the financial statements of each company they analyze. How long does it take a human being to do such work? A human being can probably be competitive with a computer if the scope of the investigation covers only the amount of material that human would examine.

Per the above: no investor, disciplined or otherwise, professional or amateur, human or computer should be doing any work to analyze individual companies when it comes to setting up long-term retirement investment funds.

But if we extend the scope of the investigation beyond that limit by using algorithms designed by humans on the theme of "These are things I would do if I only had the time and resources" then computer programs have the advantage.

Certainly: but anything times zero is still zero. Since the above stats show us conclusively that managed funds don't beat the market, we flat-out shouldn't be using them -- human or computer managed.

(For example, it is claimed that some HFT algorithms can consider breaking news stores - i.e. they analyze text data. So is it a stretch to think that a program trying to do long-term investing could analyze articles written about a company ?)

I think it is entirely possible that HFT trading, news analysis and psychology may combine to beat human trends in investing. The problem is that since HFT already dominates trading, the ability of humans to change market values with impulse-buys/sells is already been reduced.

And in any case, as someone pointed out above, this has nothing to do with long-term investing. They are fundamentally different games that do not impact each other. Indeed, day-trading, unlike investing is zero-sum. It is theoretically required to have both winners and losers, whereas for investing it is theoretically possible to have only winners.

Human long term investors aren't supposed to "buy and hold" blindly.

Yes they are. That's what "buy and hold" means. Since nobody can beat the market in the long term except by luck, nobody should be trying.

The only significant change people should be making is adjusting to life change and aging:
-Sell a house, buy stock with the the proceeds.
-Get older, reduce your risk level.

I suppose it's possible that increasing the amount of data used to make a prediction about a stock will not increase the reliability of the prediction. That would keep the world of long term investing safe from the invasion of computers.

This goes back to our earlier conversation: you still have not outlined exactly what that would look like/how it would manifest. I'm contending that because day-trading/HFT and investing are fundamentally different games, they do not impact each other in any meaningful way. I think you are operaing on a misconception about how the markets work, but I haven't figured out what yet -- perhaps the zero sum game misconception?

 

[NTL2009]

...
Per the above: no investor, disciplined or otherwise, professional or amateur, human or computer should be doing any work to analyze individual companies when it comes to setting up long-term retirement investment funds. ...

Excellent points about the professional money managers who simply do not beat the market consistently. I just want to add that this appears so counter-intuitive to most people, that I feel it is worth some expansion:

We live in a world where we have learned that we can generally expect a professional, such as a plumber, carpenter or brain surgeon, to do a better job than an untrained amateur. They have the education, training, experience, and tools for the job. So people expect the same from financial 'professionals' in terms of stock picking.

But as we've shown, stock picking is about future prices. And no amount of education, training, experience, or tools can help predict the future. And whether you accept this explanation or not is actually irrelevant. The facts are as russ_watters stated - most money managers do not consistently beat the indexes. What makes you think you can?

I put more faith in the idea that a broad group of companies in general will continue to create value, and therefore enrich me with my investments in them, than I have faith in the idea that I can pick the 'winners' and 'losers' among them. I'm retired, so being wrong could be very painful. I'll stick to the game that has an evidence based (this is a physics forum after all) advantage for me.

 

[Stephen Tashi]

competitive in that market, etc. OK, but that information is available and is already reflected in its stock price.
.

It's an interesting assumption that the consensus reached by "the market" implicitly accounts for all the relevant information. Why is that assumption sound? For example an investor with a million dollars to invest in a stock can have more affect on its price than an investor with half that amount. Is the investor with more money twice as wise?

I agree with the argument that by the time the average human investor had realized there is a change in the fundamentals of a stock then the price of the stock will probably already have changed. However, speedy investors or speedy computer programs might realize things quicker than the consensus of the market.

I recall a situation in a book by Feynman where he told of a controversy about the content of science textbook. I think he reviewed it for a school board. His criticisms of the book were met by the objection that the book was given a high average rating in a survey of a large number of engineers and scientists. Feynman said he didn't claim his opinion was better than that of the smartest engineers and scientists, but he thought it was better than the average opinion.

 

[NTL2009]

It's an interesting assumption that the consensus reached by "the market" implicitly accounts for all the relevant information. Why is that assumption sound? ...

Did I say it was "sound"? No. I only said "it was". So for you to have a different assessment than "the market" would indicate you know something the others don't. I don't think that is likely (and it may be illegal) on a consistent basis. But I do think it is possible from time to time. I do think "the market" can over/under-react to news, or the view of the average person may be different than some people more familiar with the industry (but the "pros" doing the big buying know specialists in the field).

But as I said earlier, the reasons barely matter. If this was do-able consistently, we'd see a LOT of managed funds consistently outperforming the market, there is huge motivation for this - but we don't. If you are convinced you can do this, start a mutual fund.

Could computers identify some of this, either anomalies or just be faster to react to news? Possibly, but some of that still is predicting the future. But they will be in competition with other computers, and things will average out over time anyhow. If company xyz hits $100, it matters little if I bought it for $20 ten years ago, or $19.99 ten years ago. And most of these computer algorithms are down to scrapping a penny or less here and there. I don't think it will fundamentally change things. I could be wrong, but if it is fundamentals that drive the market in the long run, I just don't see how some computers getting in a little early can have any large effect.

 

[Stephen Tashi]

The performance of actively managed funds is so bad that just by luck, you would expect half of them to beat the S&P and 5% basically means they are all bad. So you can essentially say that all managed funds are a bad idea because the only way for them to beat the S&P is by luck.

That's like saying if 95% of high school students can't understand theoretical physics, we should give up expecting any of them to understand it.

I agree with the advice that index funds are good choice if the decision is to pick an index fund at random versus pick a managed fund at random.

Per the above: no investor, disciplined or otherwise, professional or amateur, human or computer should be doing any work to analyze individual companies when it comes to setting up long-term retirement investment funds.

(!) I wonder what salaries pension fund managers make.

Since the above stats show us conclusively that managed funds don't beat the market, we flat-out shouldn't be using them -- human or computer managed.

Are there yet many computer managed funds? Do we have extensive statistics about their performance?

This goes back to our earlier conversation: you still have not outlined exactly what that would look like/how it would manifest.

I merely asked a question. I don't know how computers will impact the long term behavior of the stock market.

I'm contending that because day-trading/HFT and investing are fundamentally different games, they do not impact each other in any meaningful way.

That's wasn't the focus of my question. HFT came up only as an example that computers are already a factor in the markets.

I think you are operaing on a misconception about how the markets work, but I haven't figured out what yet -- perhaps the zero sum game misconception?

At least I know some facts about HFT and the various stock exchanges.

 

[NTL2009]

That's like saying if 95% of high school students can't understand theoretical physics, we should give up expecting any of them to understand it ...

No, it's not like that at all.

The funds in the study have professional managers, not just picked at random.

It's more like saying if 95% of scientists cannot replicate the published results of an experiment, then maybe that result should be questioned?

I agree with the advice that index funds are good choice if the decision is to pick an index fund at random versus pick a managed fund at random.

No again. Look some more into the studies of actively manged funds. Very few of those 5% that beat the market in a five year period, are able to repeat the performance in the next 5 year period (which is what matters to us).

So how are you going to pick a 'better than average fund'? And if I do a modicum of research on an index fund, I have a very good chance that it will perform in a very tight band around its benchmark, trailing a bit by the small fees/expenses most of these have, and a bit up/down depending on how closely they can replicate the benchmark. It won't be a random pick, it will be an educated one based on information, not a Crystal Ball.

 

[Stephen Tashi]

Did I say it was "sound"? No. I only said "it was". So for you to have a different assessment than "the market" would indicate you know something the others don't. I don't think that is likely (and it may be illegal) on a consistent basis. But I do think it is possible from time to time.

I agree if we are talking about "you know" meaning me, since I am a human being. There is difference between my knowing something other people don't know because I have illegal inside information versus my knowing something because I have taken the trouble to ferret out important facts from a mass of publicly available data that others have not had time to examine. A significant significant advantage that computers have is being able to apply search procedures to large volumes of data. I think some investor's who make the current market already use sophisticated computer programs in the typical person-to-machine interface of mouse and keyboard - computer summarizes data, human analyzes the summary. I'm curious what will happen if many firms begin taking the human out of the loop.

(It interesting to me that many people who don't accept consensus opinions about politics, nuclear power, global warming etc, are willing to defer to the consensus opinion of "the market" about stock prices. I haven't followed your (NTL2009) posts on diverse issues, so I don't know if you are such a maverick. I myself am not such a maverick that I'm determined to ignore consensus opinions on all subjects, but when it comes to "the market" I'll be a little skeptical.

 

[russ_watters]

Succinctly: It is a myth that managed funds do better than index funds. (this should be added to the financial knowledge thread). They don't. In fact, almost all of them do worse.

http://www.marketwatch.com/story/wh...-funds-beat-the-sp-than-we-thought-2017-04-24

The performance of actively managed funds is so bad that just by luck, you would expect half of them to beat the S&P and 5% basically means they are all bad.

My point and my source, but I'm feeling like this shouldn't be possible. By definition of the word "average", half should do better and half should do worse (minor quibble about median vs mean). The fees charged should skew to somewhat less than half doing better, but 5% sounds impossibly low.

I wonder if when they factored-out the selection/success bias in managed funds, they ignored the exact same bias in indexes?

Whatever: even if the true answer is closer to 50% it doesn't change the point: managed funds are on the whole like going to a casino: the house always wins and you lose, even when you win.

 

[Stephen Tashi]

No again. Look some more into the studies of actively manged funds. Very few of those 5% that beat the market in a five year period, are able to repeat the performance in the next 5 year period (which is what matters to us).

We can look at statistics on active-human-managed investment funds versus human-managed index funds and perhaps computer-managed-index funds. As far as I know there are yet no long term active-computer-managed investment funds (is "Betterment" one of them?) , so I don't know what statistics we'd use to compare their performance.

Isn't (or wasn't) the conventional wisdom that statistics prove that short term (human) traders have poor performance? HFT added a new wrinkle to that situation.

 

[russ_watters]

It's an interesting assumption that the consensus reached by "the market" implicitly accounts for all the relevant information. Why is that assumption sound?

To say what @NTL2009 said in a different way: it isn't necessarily "sound", it is circular. The value is what it is because it takes certain information into account and in doing so decides/makes that information the relevant information.

For example an investor with a million dollars to invest in a stock can have more affect on its price than an investor with half that amount. Is the investor with more money twice as wise?

No, but he can change what information is relevant/dominant in affecting the price. I think you think this fact is important/relevant/meaninful/dangerous, but it isn't. It's all in there already.

I agree with the argument that by the time the average human investor had realized there is a change in the fundamentals of a stock then the price of the stock will probably already have changed. However, speedy investors or speedy computer programs might realize things quicker than the consensus of the market.

So I think we largely agree that short term trading is a gambling game where some can win and others lose. But I think you are still under the mistaken impression that this is the same game long-term investors are playing and can affect that game. It isn't/can't.

 

[gleem]

Per the above: no investor, disciplined or otherwise, professional or amateur, human or computer should be doing any work to analyze individual companies when it comes to setting up long-term retirement investment funds.

That goes against common sense. How do you choose a company to invest in without due diligence in evaluating the performance of the company and using trusted techniques in assessing the possibility of future success? You need to understand what the company is doing how it is doing it and determine when the company is no longer able to reasonably live up to your expectations.

 

[russ_watters]

That's like saying if 95% of high school students can't understand theoretical physics, we should give up expecting any of them to understand it.

No, it really isn't. In this example, *none* of them understand physics.

I agree with the advice that index funds are good choice if the decision is to pick an index fund at random versus pick a managed fund at random.

You're trying to find a way around the fundamental issue: if we knew which 5% were "good" and they were *actually* good, we could just invest with them and all the rest would go away, leaving us, in short order, only with those "good" funds. The fact that this doesn't happen tells us that these "good" funds simply don't exist.

(!) I wonder what salaries pension fund managers make.

They make a ton of money, especially considering that they reduce value instead of increasing it.

Are there yet many computer managed funds? Do we have extensive statistics about their performance?

All managed funds are at least in part computer managed.

I merely asked a question. I don't know how computers will impact the long term behavior of the stock market.

Fair enough: I got the impression you thought they could had had an idea of how.

That's wasn't the focus of my question. HFT came up only as an example that computers are already a factor in the markets.

Fair enough.

 

[russ_watters]

It interesting to me that many people who don't accept consensus opinions about politics, nuclear power, global warming etc, are willing to defer to the consensus opinion of "the market" about stock prices.

I'm not sure about the former, but on the latter, I think what you are missing here is that it doesn't matter if you accept the consensus opinion or not, you are still bound by it. A share of facebook stock costs $149 today, whether you agree that it is properly priced or not! If you want to buy or sell today, that is the price you have to buy/sell at. I have exactly as much ability to change how stock prices are determined as I do to change the weather. So I had better accept it and dress accordingly.

 

[Stephen Tashi]

So I think we largely agree that short term trading is a gambling game where some can win and others lose.

In any stock transaction, whether by short or long-term holders of stocks, both sides can gain. The seller gains immediate funds, the buyer gets hope of future gains. I agree that buyer can lose if his future gain doesn't materialize. I agree that the seller can lose vis-a-vis what he originally paid for the stock or lose the opportunity of making an even greater gain had he not sold.

But I think you are still under the mistaken impression that this is the same game long-term investors are playing and can affect that game. It isn't/can't.

That wasn't the focus of my original question, but I've seen no proof that it can or can't.

By the way, it would be a mistake to think that people who supervise index funds don't do a lot of short-term trades. They must do a lot of trades unless they close themselves to new investments and redemptions. It's the actively managed funds that can get away with by-laws that allow them to do fewer trades.

There are "closed-end" mutual funds that do not directly accept investments. Instead they have stocks that are traded like the stocks of other companies. (Are we permitted to mention specific stocks in this thread? I could give an example.) Some closed-end funds are index funds over an index for a market sector - like technology. It's interesting to read the variety of indexes that such funds use. Many are quite obscure and I often wonder whether they are only used by one single index fund. I think closed-end index funds obligate themselves to fewer trades than open-end funds because there is no such thing as redemptions or new investments to a closed-end fund.

 

[Stephen Tashi]

I'm not sure about the former, but on the latter, I think what you are missing here is that it doesn't matter if you accept the consensus opinion or not, you are still bound by it.

You aren't bound by its forecast of the future value of a stock. If you think the stock will be worth more than the current market price implies then you reject the opinion of the market by buying the stock at the market price.

 

[russ_watters]

That goes against common sense. How do you choose a company to invest in without...

You're assuming we need to choose and then asking how. What I'm saying is the premise is flawed: we should not be choosing.

 

[russ_watters]

In any stock transaction, whether by short or long-term holders of stocks, both sides can gain. The seller gains immediate funds, the buyer gets hope of future gains.

Hope of future gains is not gains.

The shorter the term of the holding, the higher the future gains can be, and the higher the losses can be, amplifying the effect of the skill of the traders vs the long-term value gain of the stock. If $100 in stock becomes $110 in stock in a year, the gain is $10 or 10%. But when two entities trade that stock back and forth a million times in that year, if one of them is 1% better than the other, that guy ends up earning a $1,000,005 dollars and the other guy ends up losing a $999,995 dollars.

That's what it means for day-trading to be "essentially" zero sum.

That wasn't the focus of my original question, but I've seen no proof that it can or can't.

Consider:
3 guys walk into a casino. Two of them sit down at a poker table, playing only against each other, and the 3rd watches. At the end of the day, 1 person has a little more money, one person has a lot less money, one person has the same amount of money and the house has gained some money.

Investing works the same way except that the value of the money grows on its own, without you doing anything. So the same 3 people start with $1 apiece. At the end of a certain time period when the value of the market doubles, the person who invested in an index fund has $2, the better daytrader has $2.25, the worse daytrader has $1.25 and the brokerage firm has $0.50.

The daytraders don't affect the index fund investor because the index fund investor declines to ever trade with them!

By the way, it would be a mistake to think that people who supervise index funds don't do a lot of short-term trades. They must do a lot of trades unless they close themselves to new investments and redemptions.

That isn't what active management is. Active management is changing the allocation of the money in the fund, not the amount of money in the fund.

 

[gleem]

You're assuming we need to choose and then asking how. What I'm saying is the premise is flawed: we should not be choosing

I am definitely missing something here. You need t choose to invest. How do you know what to invest in.

 

[russ_watters]

You aren't bound by its forecast of the future value of a stock. If you think the stock will be worth more than the current market price implies then you reject the opinion of the market by buying the stock at the market price.

On the small/individual scale yes, on the large scale, no. On the large scale, the present and future prices are set by a consensus collection of metrics and logic. Since that collection sets both the current and future price (to the extent that the future price is predictable), that's the value to shoot for. That's why it is circular that over the long term, the market value is what it is, based on logic that is what it is and the average investor, by definition of "average", follows/sets that logic/price.

 

[russ_watters]

I am definitely missing something here. You need to choose to invest. How do you know what to invest in.

You choose you risk tolerance, which sets the types of funds (stocks vs bonds, etc.), and then DON'T choose the individual securities to own. Choose index funds instead.

I'll pull some quotes tonight from my go-to book on the subject, but essentially the advice is that for the vast majority of investors, the vast majority of their money should be in index funds like the S&P, not individual stocks.

 

[TeethWhitener]

By the way, it would be a mistake to think that people who supervise index funds don't do a lot of short-term trades. They must do a lot of trades unless they close themselves to new investments and redemptions.

This isn't really how open-ended funds work. Traditional open-ended mutual funds only settle up once a day, and ETFs aren't directly available to most individual investors. Instead, financial institutions will do an in-kind trade of blocks of ETF shares with a basket of the underlying stock. This allows ETFs to be traded on exchanges like a stock, but it also means that the price of an ETF can diverge from the underlying net asset value. But in the market, this problem quickly solves itself via arbitrage. (This mispricing is, of course, almost immediately gobbled up by high frequency traders.)

 

[russ_watters]

...if we knew which 5% were "good" and they were *actually* good, we could just invest with them and all the rest would go away, leaving us, in short order, only with those "good" funds. The fact that this doesn't happen tells us that these "good" funds simply don't exist.

...er, well, this is only partially true. The best at anything always rise to the top. It's just that...can anyone guess what the largest funds are...?

 

[gleem]

You choose you risk tolerance, which sets the types of funds (stocks vs bonds, etc.), and then DON'T choose the individual securities to own. Choose index funds instead.

I missed that the discussion was on index funds. Index funds are constituted to a certain set of criteria so there are choices of classes of stock that have something in common like small cap or mid cap. So someone is doing some choosing in making the funds and you choose the one you think will do the best.
Fidelity has about 20 index funds to choose from. ETF are still essentially mutual funds except without the need to analyze any of the components

 

[jtbell]

Index funds are constituted to a certain set of criteria so there are choices of classes of stock that have something in common like small cap or mid cap. So someone is doing some choosing in making the funds and you choose the one you think will do the best.

Unless, of course, you choose to take all the classes together by choosing a total market index fund.

 

[gleem]

Unless, of course, you choose to take all the classes together by choosing a total market index fund.

And that's a good choice? The major indices only have a fraction of all the publically traded companies. In the last 5 years the Nasdaq is about 60% higher than the DOW industrials or the S&P. Interestingly the DOW and the S&P 500 have increase about the same amount even thought the DOW industrial contain only 30 stocks. So what to choose.

 

[russ_watters]

I missed that the discussion was on index funds. Index funds are constituted to a certain set of criteria so there are choices of classes of stock that have something in common like small cap or mid cap. So someone is doing some choosing in making the funds and you choose the one you think will do the best.
Fidelity has about 20 index funds to choose from. ETF are still essentially mutual funds except without the need to analyze any of the components

Yes; caveat on total market funds aside, they are still sort of actively managed, but with a much simpler set of criteria designed to mirror a market segment as opposed to seeking market beating growth, and not by the investment company (so there is no management to pay for).

 

[Stephen Tashi]

The daytraders don't affect the index fund investor because the index fund investor declines to ever trade with them!

The index fund in which index fund investor invests must do short term trading. An investor who wishes to behave as the investor in your example must buy the stocks that track the index and then hold them himself - which might not a be a bad idea for someone who can afford to do that.

That isn't what active management is.

Did I say it was?

Active management is changing the allocation of the money in the fund, not the amount of money in the fund.

The point I made was that index funds must do short term trades. One day new money comes in and they are required to invest it in the stocks that are on their index. The next day people redeem their shares and the fund must sell some of the same shares to get the cash to pay out.

 

[russ_watters]

And that's a good choice? The major indices only have a fraction of all the publically traded companies. In the last 5 years the Nasdaq is about 60% higher than the DOW industrials or the S&P. Interestingly the DOW and the S&P 500 have increase about the same amount even thought the DOW industrial contain only 30 stocks. So what to choose.

No, total market, not market index. These funds are composed of thousands of stocks.

 

[Stephen Tashi]

. On the large scale, the present and future prices are set by a consensus collection of metrics and logic.

The actual future prices aren't set by anything in the present.

Since that collection sets both the current and future price (to the extent that the future price is predictable), that's the value to shoot for.

That implies that you accept the current market price as the most accurate prediction. If so, what exactly does it predict?

 

[Stephen Tashi]

No, total market, not market index. These funds are composed of thousands of stocks.

Which particular index funds hold thousands of stocks? - you do mean stocks from thousands of different companies, correct?

 

[russ_watters]

The index fund in which index fund investor invests must do short term trading.

Not in the way you are suggesting, it doesn't. Even if they bought and sold immediatly as people order, which they aren't, the buys and sells are/would be allocated to specific investors, their accounts and their transactions. There is no cris-cross/churn of individual investors' funds. Put another way: if what you were suggesting were true, the value of a fund would not necessarily track against the index it is supposed to track against. They do - what you are suggesting does not happen.

An investor who wishes to behave as the investor in your example must buy the stocks that track the index and then hold them himself...

Again, this simply isn't true. If index funds didn't work as advertised - they didn't actually track the index - there would be no point in having them.

Did I say it was?

I would hope so, since that is the point you were responding to. If you weren't then I can't see a point to your statement.

The point I made was that index funds must do short term trades. One day new money comes in and they are required to invest it in the stocks that are on their index. The next day people redeem their shares and the fund must sell some of the same shares to get the cash to pay out.

1. This doesn't even match the "short term trades" that we have been discussing as stated.
2. They only need to settle-up the difference between yesterday's and today's deposits and withdrawals, not the actual trades. So the amount of trading they actually do is a small fraction of the amount that people put in and take out each day.

 

[jtbell]

Which particular index funds hold thousands of stocks?

Vanguard Total Stock Market Index, for one:

https://personal.vanguard.com/us/funds/snapshot?FundIntExt=INT&FundId=0085#tab=2

Click on the "Portfolio & Management" tab if it doesn't come up at first. This fund tracks the CRSP US Total Market Index, and held 3591 different stocks on May 31.

 

[Stephen Tashi]

1. This doesn't even match the "short term trades" that we have been discussing as stated.

It doesn't match up with high frequency trading. It matches up with human scale short term trading.

2. They only need to settle-up the difference between yesterday's and today's deposits and withdrawals, not the actual trades.

Is daily trading not "short term" trading?

 

[gleem]

The current price doesn't predict anything. It gives some credence on whether a stock is fairly prices or not base on a consensus of the opionions of those who have studies the concept of fairly priced e.g. some range in EPS. Value in in the eye of the analyst however near sighted.

 

[MarneMath]

It doesn't match up with high frequency trading. It matches up with human scale short term trading.
Is daily trading not "short term" trading?

Not in this sense. Daily trading or short term trading is simply trading for short term positions. ETF rebalancing are not trading to change their position but to correct the leverage ratio that is occurred with gains.

 

[Stephen Tashi]

Vanguard Total Stock Market Index, for one:
https://personal.vanguard.com/us/funds/snapshot?FundIntExt=INT&FundId=0085#tab=2
Click on the "Portfolio & Management" tab if it doesn't come up at first. This fund tracks the CRSP US Total Market Index, and held 3591 different stocks on May 31.

That's an impressive number of stocks. But the page says it has 16.5% of its holdings in ten of them.

Not in this sense. Daily trading or short term trading is simply trading for short term positions.

Are we defining "position" to mean owning a stock or not owning any of it? I agree that index funds don't do that - it would break their own by-laws. However, owning more and then owning less is still a trade that can take place over a short time span.

 

[MarneMath]

Sure, however no one speaks of short term trading in that functionality. Short term trading is taking a position for a "short" duration me it minutes or days or even weeks with the hopes that you beat a correction. ETF maintain their positions but have to rebalance their leverage ratio otherwise you'll see a divergence between the ETF value and the underlining assets. In fact, you can even say that the rebalance is really there in order to maintain their functionality not for gains.

 

[jtbell]

But the page says it has 16.5% of its holdings in ten of them.

That's probably because 16.5% of the money in the market as a whole is invested in those ten stocks. The fund holds stocks in proportion to their capitalization in the market.

 

[Stephen Tashi]

Speaking of arbitrage - no wonder the average investor can't snap-up an ETF trading below its net asset value. Enter the "AP" : http://www.etf.com/etf-education-ce...-creationredemption-mechanism.html?nopaging=1

 

[Question_]

I've been following the market for a while and have a background in economics.

Investing in property or 'real estate' is one of the safest and highest earning investments you can make. Combined with the fact that the bubble in real estate has already burst fairly recently, I'd say find a real estate fund/REIT (watch out for the fees though, as they are typically high) then put away what you can in that. They also highly tax efficient and distribute at least 90% of taxable income to shareholders.

Next, in my book for safe and high return investments, I'd look into investing in core companies. By 'core' I mean essential, think waste management, mining companies, and some other core businesses like 3M or defense companies. Commodities apart from gold (to some extent, due to the fact that gold is more of a psychological/emotional investment than one driven from analysis) tend to be subject to too much speculation.

If one doesn't want to go through the hassle of going through with picking your own stocks of choice, then I don't think there are lower costing investment portfolios than one's provided by Vanguard and Berkshire.