PF Investing Club: The Stock Market & Compounding Interest

[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.

 

[Greg Bernhardt]

Investing in property or 'real estate' is one of the safest and highest earning investments you can make.

I've heard so many landlord horror stories to keep me away from property.

 

[Question_]

Haha, well the end game of such a strategy is to own your own property and not have to answer to anyone.

 

[Greg Bernhardt]

Haha, well the end game of such a strategy is to own your own property and not have to answer to anyone.

btw I also bought a condo in 2007. In 2015 I sold it for 30% bath. Not always safe.

 

[russ_watters]

Here's some quotes from "The Only Investment Guide You'll Ever Need" (2002)
Current ed, 2011:
https://www.amazon.com/dp/0547447256/?tag=pfamazon01-20

From the chapter entitled "Choosing (to Ignore) Your Broker"

There are no brokers who can beat the market consistently and by enough of a margin to more than make up for their brokerage fees...

[and even if there are and are willing to work for you, you small-timer]...there's no way for you to know who they are.

By and large, you should manage your own money (via no-load mutual funds).

[emphasis included]

The book includes lots of details and statistics about the [lack of] performance of managed funds to back up this advice. Including that - from actual tests - you are probably better off having a literal dartboard or random number generator manage your money than a broker/fund manager.

 

[russ_watters]

btw I also bought a condo in 2007. In 2015 I sold it for 30% bath. Not always safe.

No, but if the next Great Depression comes, you can still live in your house. They don't even issue stock certificates anymore that you could wrap yourself into keep warm if you were a renter and got evicted because you can no longer pay your rent!

 

[russ_watters]

Here's some quotes from "The Only Investment Guide You'll Ever Need" (2002)
Current ed, 2011:
https://www.amazon.com/dp/0547447256/?tag=pfamazon01-20

From the chapter entitled "Choosing (to Ignore) Your Broker"

There are no brokers who can beat the market consistently and by enough of a margin to more than make up for their brokerage fees...

[and even if there are and are willing to work for you, you small-timer]...there's no way for you to know who they are.

By and large, you should manage your own money (via no-load mutual funds).

[emphasis included]

The book includes lots of details and statistics about the [lack of] performance of managed funds to back up this advice. Including that - from actual tests - you are probably better off having a literal dartboard or random number generator manage your money than a broker/fund manager.

 

[Stephen Tashi]

I've heard so many landlord horror stories to keep me away from property.

I've never met anyone who was interested in making money.

By that I mean that I've never met anyone who was interested in making money and didn't have some other side conditions on how the money was to be made. I've known people who were interested in the stock market, but not real estate and people interested in real estate who didn't trust the stock market - and people interested in real estate who would only buy land and never buildings. Then there are people interested in buying gold and silver - and the relatively fewer interested in both buying and selling gold and silver. Even if we restrict the ways of money to legal ways of making it, I've never met anyone who could free his mind of other considerations and just concentrate on the best way of making money that was at hand. I can't do it and don't want to. I wouldn't want to be a landlord.

 

[Greg Bernhardt]

No, but if the next Great Depression comes, you can still live in your house. They don't even issue stock certificates anymore that you could wrap yourself into keep warm if you were a renter and got evicted because you can no longer pay your rent!

The question is, can I pay off the mortgage before the next great depression comes

 

[russ_watters]

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

I know. Let me rephrase for clarity:
On the large scale, the present prices are set by a consensus collection of metrics and logic today and the and future prices are set by a similar consensus collection of metrics and logic at that time.

That implies that you accept the current market price as the most accurate prediction.

No, as I've said before, the current market price is the current value of the company, period. It doesn't have an "accuracy", because it isn't a prediction: it just is.

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

No, it doesn't match up with either. You're letting the fact that there are a lot of investors confuse you here. I buy into a mutual fund every payday when my 401K money gets taken out of my paycheck (26 times a year). I *never* sell. "Traders" (high frequency or human day-traders) sell about as often as they buy. The fact that the mutual fund as a whole will on average buy 125 times a year and sell 125 times a year has no bearing on me. It does not affect the value of my fund. And there is no way for the high-frequency or day-traders to affect the value of my fund by "trading" against it. That's what we're discussing.

[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?

You're not responding to what I said. I'm feeling like there is a focus issue here, like you're trying to get a "win" on a technicality rather than come to an understanding on the issue we're discussing. You do understand that a fund might both take in and put out thousands of trades worth millions of dollars in one day and then aggregate them into one trade worth a tiny fraction, right? You recognize that the frequency and value of the churn is orders of magnitude different between this and "day-traders" and "high frequency traders", right? By and large (by orders of magnitude difference in number and value), these entities are not trading against each other so they cannot win or lose money from each other. That's what we have been discussing.

 

[russ_watters]

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.

Yes, I think this is a key point: managed funds are trying to beat the market (and usually fail), whereas index funds are trying to reflect the market.

 

[Question_]

Bonds tend to be associated with governments; but, companies also issue them at a much higher yield than governments do. Just something to keep in mind for the risk-averse.

 

[Vanadium 50]

Stephen, I am still having trouble understanding your point.

Let's imagine an "infinite Treasury bill" that costs $100 and pays $5 each year forever. Now imagine a stock that pays $10 in dividends per share every year. Guaranteed. You have this on stone tablets from the mountain. How much is a share worth? Can we all agree $200?

Now in real life Treasuries last for a fixed time, but accountants can correct for that. Also in real life, the earnings per share vary, but again, accountants know how to correct for that. The basic idea is still the same - if I know the exact returns every year from now until a long time from now, everyone will agree on the price of the stock: it's the price at which you get the same return from an equivalent safe investment, like a Treasury.

Of course we don't know what the exact future returns will be. People have different ideas of what this will be, but given their assumptions, the "fair price" should be calculable. In a very real way, the fair price is single number that characterizies a complicated future return profile. And because we may differ on what the future return profile is, we disagree on the fair price.

The market provides a consensus price. I take my idea of what the future returns are, and calculate that the fair price for XYZ is $110. If it's trading for $100, I will buy it. If I buy a lot of it, maybe the price moves to $101. This is how the market is factoring in my beliefs on how XYZ will perform in the future. The "market price" is a measure of the consensus (in a statistical sense) of what the future returns will be.

Do we agree on all of this? If not, let's get on the same page before moving on.

Now, how do computers factor into this? They can do so in two ways - they can make better decisions or they can make faster decisions.

On the better decisions front, we are already in a situation where the individual investor is handicapped. The Big Boys employ analysts who spend their whole days looking at data that might influence future returns. The individual investor simply doesn't have these resources. Trying to beat the market by out-analyzing the analyzers is, in my view, a fool's errand, with or without computers.

On the faster front, new information needs to be processed by a human brain. If the annual report says "Instead of the usual $1/share dividend, this year it will be only 75 cents because we are investing in new technology, and we expect future dividends to be $1.25/share." Does this mean the stock should go up, or should it go down? Clearly it depends on the credibility of the claim that this new technology will produce a permanent increase in profitability, and that means some human being needs to think about it. And that will limit how fast this new information can be priced in - it will happen at human-scale times, not computer-scale times.

 

[Vanadium 50]

btw I also bought a condo in 2007. In 2015 I sold it for 30% bath. Not always safe.

But not necessarily stupid. Let's say it was $200K in 2007 and $140K when you sold it, and you put 20% down. You'd have lost $60K in the price, and gained $11K in equity, and have spent about $800 a month for the mortgage. So it cost you $1300/month. How does that compare with renting? Maybe better, maybe not, but a house is more than an asset.

 

[Stephen Tashi]

By and large (by orders of magnitude difference in number and value), these entities are not trading against each other so they cannot win or lose money from each other. That's what we have been discussing.

1) The topic of day trading is not my original question.
2) Day traders are not necessarily trading "against each other". You choose to imagine a scenario where they are.
3) High frequency trading programs make profits so that short time-span version of trading is profitable to computer programs. Whether you want to call that "short term trading" or "day trading" can be a vocabulary debate.
4) The fact that human day traders supposedly don't make profits would support the idea that computers can out perform humans in short term trades.

You're not responding to what I said. I'm feeling like there is a focus issue here, like you're trying to get a "win" on a technicality rather than come to an understanding on the issue we're discussing.

5) It's not me that has a fixation on bad-mouthing active human-managed mutual funds on the basis of what I read in one book. I don't know why that crusade interests you. It's not the topic that I proposed discussing. You seem to think my question implies that I advocate investing in actively managed funds or advocate short term trading. I don't advocate either as a general policy. I don't do short term trading. I have invested in a few actively managed funds and am pleased with their performance. As far as I can tell, the statistical inferiority of the collection of human-actively-managed mutual funds versus index funds has no bearing on my question about how the increasing use of computer programs will affect long term investing - except that it might be an argument that computers will dominate long term investing. Index funds are essentially executing an algorithm that is defined by an index. There can be different indexes. Following a particular index might be a good idea and it might be a bad idea. Humans have invented different indexes. Computer programs might discover better indexes to follow.

 

[russ_watters]

Great post, @Vanadium 50,

I of course agree on all the background logic, but may have a slightly different take on the prospects for computers in trading:

On the "better" front, you're absolutely correct that we as individual investors have already lost (and will continue to lose) and have no hope of winning against professionals over the long-haul when it comes to deciphering and making decisions on the data. But Stephen's question is: can it get worse? My answer: certainly. Their ability to decipher data can only get better as they learn and computers help them do more and more complex analysis. But more importantly: It doesn't matter. If you follow the advice I've referenced and decline to play against the professionals, you can't lose to them.

On the "faster" front, I only half agree. Humans write the algorithms/programs, and as such I believe you can program a computer to replace a human, doing the same "better" job also faster, giving an additional edge over individual investors when it comes to making [snap] decisions. Ultimately, a piece of news does get processed by people - that's how the consensus impact of the news is eventually reached - but it takes time.

Say, for example, a drug in trials gets a surprise rejection by the FDA. The company stock plunges rapidly on the news, then people regain their senses over the next few days and the stock recovers most of its losses. It seems to me that it should be possible for a computer to recognize this, and if nothing else be the first to sell when the bad news hits the AP wire...and maybe even know roughly when to buy-back if the psychology takes tanking stocks on a consistent roller-coaster.

But again, this doesn't really matter to most of us. We can't lose this game if we don't play...or actually, we win this game by not playing, just like the guy who watched his two friends at the casino instead of playing with them went home a winner (second place and with an above-average return).

 

[Stephen Tashi]

Stephen, I am still having trouble understanding your point.

Let's imagine an "infinite Treasury bill" that costs $100 and pays $5 each year forever. Now imagine a stock that pays $10 in dividends per share every year. Guaranteed. You have this on stone tablets from the mountain. How much is a share worth? Can we all agree $200?

No, and that's why economic theory is so complicated. It has to deal with "utility" as a separate concept from "price" I wouldn't pay $200 for such a treasury bill today if there was another bill selling for $150 that paid $11 yearly dividends. I wouldn't pay $200 for such a treasury bill if preferred to spend my $200 to buy something right now. If I owned such a treasury bill, I might not wish to sell it for $200.

Modeling how the market price for such a treasury bill is reached is an interesting mathematical problem. You have a population of buyers and sellers with different "utilities" and different reserves of capital or bonds to use in pursuing their goals. If we assume a lot of buying and selling takes place we can formulate a model where some (dynamic) equilibrium price is reached.

The market provides a consensus price. I take my idea of what the future returns are, and calculate that the fair price for XYZ is $110. If it's trading for $100, I will buy it. If I buy a lot of it, maybe the price moves to $101. This is how the market is factoring in my beliefs on how XYZ will perform in the future. The "market price" is a measure of the consensus (in a statistical sense) of what the future returns will be.

The market price, no doubt, is affected by market participants' predictions on the future. Your personal beliefs affect he market price insofar as you have resources to buy or sell the stock in the market. However, there is no unique way to look at the current price of a stock and interpret it as a specific prediction about the future value of a stock. The market price is the result of complex interaction among participants with differing predictions and differing measures of utility and differing assets to deploy in the market.

It is true that a person can compare a stock selling for $200 per share with the idealized treasury bill in your example and consider whether his personal preference would be for the stock or for the treasury bill.

The market price set by a population of human participants is not necessarily the same price that would be set by a population of computer programs. The volatility of the market price is also not necessarily the same. ( Whether the financial power behind a population of computer programs would be similar to the financial power behind today's human investors is an interesting question. In the different case of short term trading, the HFT programs appear to have large resources behind them. )

One of my questions is whether it is safe to assume the historical percentage returns on stocks will be relevant to a future stock market where the market participants that might have the largest resources are computer programs. (I really do understand - at least as well as anyone else in the thread - how stock markets work. So far, I haven't seen any coherent argument that begins "This is the way stock markets work" and ends with "therefore the participation of computers will not affect the percentage returns on stocks". (And I also havent' seen an argument that concludes "therefore the the participation of computers will affect the percentage returns". ))

 

[NTL2009]

NTL2009 said: ↑
Did I say it was "sound"? No. I only said "it was". ...

...

(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.

I think this has been answered by others, but since you framed it in a direct Q to me, I will respond to that as well.

Some of my earlier responses may not have been worded as well as I intended, but the above statement is reflective of how I feel/think. The stock prices are what they are. I don't concern myself with whether they "right" or "wrong" (and don't think that personal investors should either).

The difference, one that I think you have been missing, is we are saying the price is an accurate reflection of the consensus, not that the consensus itself is accurate.

To your point about consensus on other issues, I'll throw out a make-believe hypothetical to avoid hot-button issues. If a well done, rigorous and replicated study found that 20% of the people of voting age in the US thought that Perpetual Motion machines would be providing all our energy needs by 2030, then I'd have to say that the study was correct. But those 20% are wrong. See the difference? The stock market reflects the opinions, right or wrong.

How is this relevant (which is all that matters)? I don't think it has any relevance to the personal investor. If you are in the accumulation phase, you are probably (and should be) making purchases each paycheck (called "dollar-cost-averaging" in). So if the market consensus was a little 'wrong' one day to the positive, and a little 'wrong' the next day to the negative it all averages out for you. Same concept on the way out, as a retiree drawing down their stash. And if it was always wrong in the same direction, it would wash out. Relax.

Now there are some studies about how the average P/E of the market can be a good long term indicator, and some people use this to adjust their allocation between stocks/bonds (but generally using broad-based index funds for each). I personally don't subscribe to this, I think the market can be 'wrong' for too long a period of time, and too unpredictably to use this to advantage. And other, unforeseen events can intervene - being unforeseen, they could be positive or negative. So what to do? How about..."nothing"!

So I just go with the flow, and I've never been happier. It's wonderful and amazing that taking the easy, lazy, do-nothing way, actually ends up being the best way! How often does that happen? I feel like a real-life "Wally" from "Dilbert!

 

[NTL2009]

I'm starting to feel this should be broken off to a different thread, I'm not sure a hypothetical debate on the future of computer trading is useful (though maybe interesting) to a thread on personal finance.

...
One of my questions is whether it is safe to assume the historical percentage returns on stocks will be relevant to a future stock market where the market participants that might have the largest resources are computer programs. (I really do understand - at least as well as anyone else in the thread - how stock markets work. So far, I haven't seen any coherent argument that begins "This is the way stock markets work" and ends with "therefore the participation of computers will not affect the percentage returns on stocks". (And I also havent' seen an argument that concludes "therefore the the participation of computers will affect the percentage returns". ))

I think the answer actually is buried in some of the earlier replies, but let me give it a shot anyway:

So let's say XYZ corp trades today at $10/sh, and I have purchased some through a paycheck direct deposit, in the form of a broad based mutual fund that owns hundreds, maybe thousands of stocks. Shares of ABC Corp also are in that index, and also trade at $10/sh. I also buy these with every paycheck for many years.

30 years later, in our hypothetical world w/o significant computer trading, let's say those companies have done well, and are now trading at $300/sh. I start drawing the divs, and maybe a little principal from time to time, to fund my retirement.

OK, parallel world, with heavy computer trading:

Was $10 for XYZ and ABC corp "right"? I dunno, maybe I should have paid $9 for XYZ and $11 for ABC, or vice-versa, or $9 each or $11 each? And what about next paycheck? Same or different? And how about the $300 years later? High, low? Averaged over time - does it matter? I don't think so.

Maybe a bit more real-world - would computers have detected the tech bubble of the late 1990's into 2000? Let's say they did, I think that would mean tech would not have rose so high, and would not have crashed so hard. But that had zero effect on me, I kept my asset allocation throughout. Same with the 2008 scenario. Relax, don't worry, enjoy life.

"Smart" computer trading might lower volatility if we assume the consensus is wrong sometimes (too high or too low). That's a good thing for a retiree (drawing down), but actually, volatility is good for a dollar cost average investor - they get more shares on the dips! Overall, I wouldn't worry about it.

 

[Stephen Tashi]

The difference, one that I think you have been missing, is we are saying the price is an accurate reflection of the consensus, not that the consensus itself is accurate.

What I say is that the "consensus" price isn't a consensus about anything - i.e. it is not a consensus about any particular statement. So it isn't meaningful to say that the consensus price is accurate or inaccurate in a "global" sense. An individual can interpret the consensus price in terms of whether the price is a good deal or bad deal according his personal measure of utility.

The stock market reflects the opinions, right or wrong.

I agree that the stock market is affected by a variety of opinions about factual matters. But it is also affected by personal preferences and how much money different people have to pursue those preferences in the market. So the stock market reflects opinions, but not a specific opinion.

I'm starting to feel this should be broken off to a different thread, I'm not sure a hypothetical debate on the future of computer trading is useful (though maybe interesting) to a thread on personal finance.

I don't object to that. However, this portion of the thread had revealed some interesting variations in how participants think stock markets work and what market prices mean.

 

[NTL2009]

NTL2009 said: ↑
I'm starting to feel this should be broken off to a different thread, ...

I don't object to that. However, this portion of the thread had revealed some interesting variations in how participants think stock markets work and what market prices mean.

Don't bother on my account. Based on these responses, I won't be engaging further on this subject in this thread or any other. IMO, it has become pointless meandering, and I'm not learning anything. But to close that out from my side:

What I say is that the "consensus" price isn't a consensus about anything - i.e. it is not a consensus about any particular statement. ...

Sigh. Of course it is a consensus. It is the consensus on the price that buyers and sellers are willing to exchange their shares at, at that point in time. What you want to infer from that consensus is a different matter, but I really don't think it matters one wit to the personal investor with their money in broad based index funds.

So the stock market reflects opinions, but not a specific opinion.

Don't mean to be flippant, but really - "so what"? There's nothing actionable there for the personal investor, so they should "invest" their time learning about what can help them achieve their financial goals, rather than "angels dancing on the heads of a pin" discussion about what the price of a stock means to different people - which is what I'm going to do by dropping this conversation at this point.

Thanks.