PF Investing Club: The Stock Market & Compounding Interest

[russ_watters]

Before investing, you should build up 3 to 9 months of your salary in your savings. It isn’t good when the market drops 20 to 40 percent, and then you lose your job. All too often market drops and layoffs go hand in hand.

This is a tough one for me. I find I get antsy to have so much cash not working for me. And I'm not sure if the math really works. Having, say, $50,000 in a savings account costs you $2500 the first year, $2650 the second, $2755 the third, etc. In 8 years, the growth will be more than that 40% potential loss.

I prefer to use my home equity has my major emergency cushion...though I admit I'm not sure how easy it would be to take out a loan if I lose my job...

 

[Vanadium 50]

Russ, lets' address your second point first. An alternative to a home equity loan is a HELOC - a home equity line of credit. Like a home equity loan it is a second mortgage, but unlike one it has (typically) a ten year "draw period" where you can withdraw money from your line of credit rather than get one lump sum all at once. That way, you pay money only as you need it. One advantage in your situation is that you are approved for such a loan pre-emergency

Now, onto your first point. Cash is part of an asset allocation program. It is working for you. It's reducing risk. Cash and cash-like assets are anticorrelated with the S&P500, so in bear markets, cash tends to do better. You can also use this to your advantage - having cash on hand during a bear market allows you to buy (or avoid selling) when the market is down. As they say, fortunes are made during recessions..

 

[Imager]

The 3 to 9 months is guideline, personally I ran much lower savings when I was younger. In my 50's I had about months 15, then boom the company offers a severance program and I retired.

 

[Imager]

to accumulate 3 to 9 months of salary in an account earning next to no interest would take many years.

I certainly go along with investing a little versus not building a safety fund. I do think people should have some savings to cover unexpected expenses. You should at least be able to fix a transmission or replace an A/C unit without having to sell stocks.

 

[Charles Kottler]

I prefer to use my home equity has my major emergency cushion...though I admit I'm not sure how easy it would be to take out a loan if I lose my job

Many banks are offering 'offset' accounts these days. As the name suggests these offset your current and/or savings account balances against your mortgage. The interest is calculated on the net balance, so if you owe $250,000 on the house and have $50,000 in savings, your mortgage interest is only paid on $200,000 (and you earn nothing from the savings). This allows you to effectively save at your mortgage rate which is typically much higher than the savings rate. While this does not offer quite the same growth potential as shares it is far better than most savings accounts and does still allow you immediate access to the funds.

 

[vela]

Amazon and Google are obviously giants, but they now have extremely steep prices. Would they still be a buy if you are looking at holding them for 20-30 years? Or is it better to play completely safe and throw everything into Vanguard 500? So hold tech giants for 30 years or Van500?

It doesn't have to be one or the other. You could put most of your money into index funds and use the rest to invest in individual stocks.

Index funds are the easy way to invest. Index funds are diversified, so they're relatively safe, but you're not going to get the dramatic growth you can from finding stocks that end up taking off. If you don't want to devote considerable time managing your investments, they're the way to go. You might want to look at a fund that mirrors the broader market though.

If you want to try your hand at picking individual stocks, I'd recommend reading books on investing in stocks and investing in general before you start trading. I liked Peter Lynch's books. Lynch ran Fidelity's Magellan Fund with great success over a pretty long run. In his books, he goes over the factors he looked at when evaluating different types of stocks. I also liked Burton Malkiel's A Random Walk Down Wall Street. He explains why technical analysis is stupid, and you'll learn the idea behind index funds. Vanguard's website also has a lot of good info on investing.

 

[Vanadium 50]

Many banks are offering 'offset' accounts these days

In the US? Washington Mutual had something like this right before they went under.

. Index funds are diversified, so they're relatively safe, but you're not going to get the dramatic growth you can from finding stocks that end up taking off.

But you're also avoiding the dramatic losses you can get from finding stocks that end up tanking.

 

[kyphysics]

Actually, your mutual-fund company (if you invest in their funds directly with them) or your brokerage (for stocks and ETFs) has to keep track of cost basis for you. This is a fairly recent thing, since about 2010 or so. At least for mutual-fund companies, not sure about brokerages. Every year they send you a form 1099-B that reports the details of the gains on your sales, for your tax returns. TurboTax and other tax software can import these online so you don't have to type in the numbers yourself. I still like to do it by hand with a spreadsheet, to check their figures and because I feel more comfortable when I understand what's going on.

However, all my ongoing monthly contributions have been to my tax-deferred 403b plan at work, where this doesn't come into play.

I set up my taxable brokerage account with inherited money, and make trades in it only to rebalance, once a year or so. I don't reinvest dividends in that account. I'm retired now, so I collect them and use them to support part of my spending. If I do start reinvesting dividends there at some point, I'll let them accumulate and reinvest them at rebalalancing time. I keep things simple there: Vanguard Total Stock Market Index ETF (VTI), Vanguard Total International Stock Index ETF (VXUS) and Vanguard Total Bond Market Index ETF (BND).

Appreciate the response. Gotta be honest, jtbell. Too complicated for me!

Applause that you actually take the time to understand it for yourself. I think that's a great and proper way of learning. Feynman would be proud!

I probably would do the same, but since I'm not at that stage of investing yet, I don't bother to learn the tax related stuff yet. At absolute worst, I figure I could ask a professional to do it for me.

 

[jtbell]

The basic principle is simple: when you sell something for a profit, you owe tax on the profit. That means keeping track of how much you paid for it (the cost basis) so you can subtract it from the gross proceeds of the sale. Applying this principle is messy when you have a portfolio with many chunks of stock (tax lots) bought at different prices over a period of many years.

It's sort of like physics. Newton's Laws are simple, but applying them to a real-world situation with lots of moving parts can be messy.

 

[Vanadium 50]

At absolute worst, I figure I could ask a professional to do it for me.

I think you mean "hire a professional to do it for me..

 

[kyphysics]

The 3 to 9 months is guideline, personally I ran much lower savings when I was younger. In my 50's I had about months 15, then boom the company offers a severance program and I retired.

I feel like in today's volatile and slow-growth economy that having that 6 months of living expenses saved up could be wise.

One of the worst things you can do with an IRA is to put money in and then raid it for emergency cash. It's not so much the fees (I think there might not even be any on the principal?), but the lost ability to get compounding on the investment. It'd feel like a major waste of energy and time to put money in and have to take it out before you get the full effect of time and compounding. I'd want to put money in, leave it, and never have to touch it for 20 years.

A six month stash of living expenses seems like it'd cover most cases of lost jobs, random budget breaking expenses, and emergencies that could crop up. Some people might even say 9-12 months. All subjective and reasonable.

I like a bare minimum of six months. Seems like a good baseline. After that, I'd feel more relaxed and I could put money into an investment account and likely not have to raid it for cash.

 

[Stephen Tashi]

I think the majority of trades on the major stock exchanges nowadays are done by computer algorithms. It's an interesting question whether human "day traders" have suffered because of this - but that doesn't bear on the conventional wisdom for human investors, which is to do "long term" investing.

However, it's worth considering whether the historical statistics for returns on stocks will continue to be valid if computers and artificial intelligence tackle long term investing.

Any discussion of that possibility will mainly be a debate on whether adequate technology will exist for it in our life time. However, (to me) the fundamental question is one of economic theory. Do returns on stocks depend on some sort of inefficiency in how people set current prices on stocks? - or are returns on stocks mainly due to differences in tastes - personal preferences for spending now or investing for later? ( There is the notion that both sides win when a trade is executed. The seller prefers something tangible now. The buy is willing to wait.)

 

[russ_watters]

However, it's worth considering whether the historical statistics for returns on stocks will continue to be valid if computers and artificial intelligence tackle long term investing.

I don't see why they wouldn't. Fundamentally, the value of a stock is tied to the health of the company. I don't see how automation of trading could change that.

Do returns on stocks depend on some sort of inefficiency in how people set current prices on stocks? - or are returns on stocks mainly due to differences in tastes - personal preferences for spending now or investing for later?

I don't understand the questions... or maybe you're missing the third option - the actual answer - to the questions? Your first question seems to imply that stocks grow in value over time because they are priced to low now. No: they grow over time because they - the company they represent - become more valuable over time.

 

[Stephen Tashi]

I don't see why they wouldn't. Fundamentally, the value of a stock is tied to the health of the company. I don't see how automation of trading could change that.

Aren't historical returns on stocks dependent on the degree of accuracy (as far as predictive accuracy) that went into setting the day-to-day price of stocks over that history? If an investor (human or computer) was statistically more accurate than other investors at predicting future stock prices, it seems to me that his historical returns would be higher than other investors. The historical returns on stocks are based on historical prices that were negotiated among a mix of investors with diverse skills at prediction.

Automation of trading, need not not change the current or future health of a company, but it might (eventually) be able to make more reliable estimates of current and future health of a company and thus be more skilled at setting a fair current price for a stock than non-algorithmic traders.

If computer algorithms become more skilled at setting fair prices for stocks than negotiations among a mix non-algorithm investors then these algorithms will dominate the market. They will be buying and selling versus other algorithms with similar skills. The daily market price of a stock will be dominated by what the algorithms cause to happen.

I agree that a market dominated by algorithms can still show positive returns from a buy-and-hold strategy. I'm just asking whether estimating the size of these returns from historical data is a good guide to what would happen under such different circumstances.

 

[russ_watters]

Aren't historical returns on stocks dependent on the degree of accuracy (as far as predictive accuracy) that went into setting the day-to-day price of stocks over that history?

That's a confusing statement. The return is based on selecting/purchasing a mix of stocks and the return of those stocks. Selecting the stock mix doesn't "settle" (set?) the price. I'm not sure what you are getting at with that word. Perhaps more importantly, the whole point of the buy-and-hold strategy is that the short-term fluctuations average-out over the long term.

If an investor (human or computer) was statistically more accurate than other investors at predicting future stock prices, it seems to me that his historical returns would be higher than other investors.

Yes.

The historical returns on stocks are based on historical prices that were negotiated among a mix of investors with diverse skills at prediction.

Yes.

Automation of trading, need not not change the current or future health of a company, but it might (eventually) be able to make more reliable estimates of current and future health of a company and thus be more skilled at setting a fair current price for a stock than non-algorithmic traders.

Yes.

If computer algorithms become more skilled at setting fair prices for stocks than negotiations among a mix non-algorithm investors then these algorithms will dominate the market. They will be buying and selling versus other algorithms with similar skills. The daily market price of a stock will be dominated by what the algorithms cause to happen.

Ok. So what?

I agree that a market dominated by algorithms can still show positive returns from a buy-and-hold strategy. I'm just asking whether estimating the size of these returns from historical data is a good guide to what would happen under such different circumstances.

If an algorithm is ever created that is able to beat the market, it will be the first, and congratulations to its creator. But that doesn't have anything to do with the long-term investing we are discussing. It won't change the long-term prospects of normal mutual funds. If anything, it would reduce the short term fluctuations by adding a buffer against unwarranted speculation.

It almost sounds like you are intending to imply - but not coming out and saying - that if automated stock trading ever becomes successful it will reduce the long-term gains of things like index funds. Is that what you are suggesting? Can you explain why?

 

[Stephen Tashi]

That's a confusing statement. The return is based on selecting/purchasing a mix of stocks and the return of those stocks. Selecting the stock mix doesn't "settle" (set?) the price.

Calculating return from historical data requires assuming you bought a stock (or a mix of stocks) at some historically "current" prices. Return calculations are not independent of your purchase prices. If purchase prices become based on more accurate forecasts then their relation to future prices may change.

For example, investments such as bonds have a higher degree of predictability that stocks. Their historical returns are (I think) lower than returns on stocks because their purchase prices are computed free of much of the unpredicatability associated with stocks. If the future of stocks were to become more predictable, they might become more like bond investments and give lower percentage returns.

If an algorithm is ever created that is able to beat the market, it will be the first, and congratulations to its creator.

As I said, one objection to the scenario of computers taking over long term trading is that it is impossible. But it's worth pointing out that the computer take-over of short term trading is not due some new kind of intelligence. Computer trading algorithms make the same decisions that common sense human traders make, but computers do things faster. Short term computer trading algorithms do beat the market.

But that doesn't have anything to do with the long-term investing we are discussing.

Anything that causes a major change in how current prices for stocks are derived will have an effect on long term investing. Long term investors must buy at some current price.

 

[russ_watters]

Calculating return from historical data requires assuming you bought a stock (or a mix of stocks) at some historically "current" prices. Return calculations are not independent of your purchase prices.

Agreed.

If purchase prices become based on more accurate forecasts then their relation to future prices may change.

For individual cases or in the short term, but not in the aggregate. On the whole, the value of the stock market is what it is.

For example, investments such as bonds have a higher degree of predictability that stocks. Their historical returns are (I think) lower than returns on stocks because their purchase prices are computed free of much of the unpredicatability associated with stocks.

Correct: bond returns are guaranteed.

If the future of stocks were to become more predictable, they might become more like bond investments and give lower percentage returns.

Not correct. You should never forget that in the aggregate the value of stocks is the value of the companies the stocks represent. The only way for the returns to be substantially different over the long term is for the value of the companies to be substantially "wrong" over the long term. "Unpredictable" means some are wrong high and some are wrong low over the short term, but over the long term the returns become more stable -- the unpredictability averages out.

For example, if a lot are wrong high, that's called a "bubble". Bubbles don't last forever though; they burst, bringing the market on the average (the aggregate) back to a reasonable price.

As I said, one objection to the scenario of computers taking over long term trading is that it is impossible.

I don't know who would say that/what it means because it is quite possible and is being done. Heck, to some degree computers are trading for me: buying stocks automatically for me every payday!

But it's worth pointing out that the computer take-over of short term trading is not due some new kind of intelligence. Computer trading algorithms make the same decisions that common sense human traders make, but computers do things faster. Short term computer trading algorithms do beat the market.

On the whole, no they don't. If someone had a winning formula, everyone would know it and everyone would invest with that company.

Anything that causes a major change in how current prices for stocks are derived will have an effect on long term investing.

Again: not on the whole, it won't. In order for the long term value to be affected, either the price now or the price then has to be substantially "wrong". And on the whole, the value of the stock market isn't "wrong", it is what it is.

Edit:
Let's be a bit more specific:

When someone says the current stock market is "wrong" or "right" (over or under valued), what they are talking about is the p/e ratio. Here's the historical p/e ratio:
http://www.multpl.com/

The historical average is between 15 and 20. It might vary naturally due to economic growth or recession, but overall it should always return to that range. If the computers have the effect of making the market more accurately rated, what they will do is flatten-out that graph, softening the boom and bust cycle. But they will not change the range, because in the aggregate that's what the range is "supposed to" be.

 

[Stephen Tashi]

On the whole, the value of the stock market is what it is.

That's a tautology, of course. Are you saying there is a "true" value of a collection of stocks that doesn't depend on their current prices?

Not correct. You should never forget that in the aggregate the value of stocks is the value of the companies the stocks represent.

You seem to be making a distinction between "value" and "price". I agree that such a distinction is theoretically possible, but how do you intend to quantify "value"?

"Unpredictable" means some are wrong high and some are wrong low over the short term, but over the long term the returns become more stable -- the unpredictability averages out.

Computing long term statistics based on historical data shows post-dictability, not pre-dicitability. What I'm asking about hypothesizes a change in the nature of the mix of "some are wrong high and some are wrong low".

On the whole, no they don't. If someone had a winning formula, everyone would know it and everyone would invest with that company.

On the whole they do "beat the market" - they trick the market. High frequency trading algorithms don't try to pick companies. They deal in stock prices. There are many different stock exchanges. Beside the major exchanges, there are also the "dark pool" exchanges. As a simple case, if an offer to sell 1000 shares of company X at 14 comes up on one exchange and an offer to by 950 shares of company X at 15 1/4 comes up on another exchange, a computer program can quickly detect the existence of this pair of offers in the stream of real time data and simultaneously buy 1000 shares of X at 14 on one exchange and sell 950 shares of X on the other at 15 1/4. (There are probably much more complicated examples of such "sure thing" situations that involve trading more than one stock and including puts , calls, futures etc.)

A human trader can, in principle, try to find the same sorts of deals, but he can't execute the algorithm (including the search for deals) as quickly as a computer.

When someone says the current stock market is "wrong" or "right" (over or under valued), what they are talking about is the p/e ratio.

That's not true of people who seek "growth stocks" The terms "over valued" and "under valued" have no standard definition.

If the computers have the effect of making the market more accurately rated, what they will do is flatten-out that graph, softening the boom and bust cycle.

I agree, that's plausible.

But they will not change the range, because in the aggregate that's what the range is "supposed to" be.

Do you mean the range of p/e's ? I think your argument that is that the financials of companies (e.g. revenue, expenses, liabilities, etc) would not be affected if predictions of the future stock prices became more accurate. That's a complicated question because a company's ability to borrow often depends on the outlook for the price of its stock. Also the "p" in p/e is based on stock price.

 

[russ_watters]

That's a tautology, of course.

Yes.

Are you saying there is a "true" value of a collection of stocks that doesn't depend on their current prices?

You seem to be making a distinction between "value" and "price". I agree that such a distinction is theoretically possible, but how do you intend to quantify "value"?

No, it seems that you are suggesting these things! I'm saying the value of the stock market (a collection of stocks) is what it is.

Computing long term statistics based on historical data shows post-dictability, not pre-dicitability. What I'm asking about hypothesizes a change in the nature of the mix of "some are wrong high and some are wrong low".

I'm aware. And I'm saying that the way that would manifest does not change the long-term outlook either forward or backwards in history.

On the whole they do "beat the market" - they trick the market.

High frequency trading algorithms don't try to pick companies. They deal in stock prices. There are many different stock exchanges. Beside the major exchanges, there are also the "dark pool" exchanges. As a simple case, if an offer to sell 1000 shares of company X at 14 comes up on one exchange and an offer to by 950 shares of company X at 15 1/4 comes up on another exchange, a computer program can quickly detect the existence of this pair of offers in the stream of real time data and simultaneously buy 1000 shares of X at 14 on one exchange and sell 950 shares of X on the other at 15 1/4. (There are probably much more complicated examples of such "sure thing" situations that involve trading more than one stock and including puts , calls, futures etc.)

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

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. 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.

That's not true of people who seek "growth stocks" The terms "over valued" and "under valued" have no standard definition.

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

I agree, that's plausible.

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

Do you mean the range of p/e's ? I think your argument that is that the financials of companies (e.g. revenue, expenses, liabilities, etc) would not be affected if predictions of the future stock prices became more accurate. That's a complicated question because a company's ability to borrow often depends on the outlook for the price of its stock. Also the "p" in p/e is based on stock price.

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.

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.

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.

 

[Borg]

I have been investing for about 30 years. I originally invested only in index funds offered through my 401K plans. These were easy to deal with, didn't require a lot of thought or maintainence but, didn't have the greatest returns. As my ability to invest increased (i.e. no debt), my wife and I started investing in individual stocks. We have made some bad decisions and some very fortunate ones.

One thing to note about the 'fortunate' stocks. Several of our high gainers went up drastically because they were purchased by other companies. Two recent ones were turned into cash when the sale finalized and we were forced to pay capital gains that year. If the gain is significant enough, this could impact your federal taxes such that you could end up underpaying by more than 10% at the end of the year. If that happens, the IRS will impose a penality.

I currently use an investment strategy designed by a friend with a masters in Economics that was turned into a program by myself. Basically, we score stocks according to many factors such as P/E ratio, historical debt, cash, etc. Blue chip and aristocratic stocks get a small bump in their score as well. The score of a stock determines its investment value which, in our case, means how many shares we would be willing to purchase. We then examine the stock manually. Finally, we don't purchase a stock if it is above its current 6 year average. This is so that we can pick up good stocks that are probably undervalued. While this limits our ability to purchase stocks that never fall below their average, it does tend to limit short term losses. I have not had any serious losers since I have been following the advice of this program.

 

[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.