PF Investing Club: The Stock Market & Compounding Interest

[gleem]

but I really don't think it matters one wit to the personal investor with their money in broad based index funds.

Actually index funds being traded like stocks can be bid up/down if buyers/sellers feel the market will rise or fall say for example for a good or bad jobs report or interest rate increase.

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 -

A current price is very actionable. you can sell or short it if you think it is too high or buy more if you think it is a bargain.

 

[Question_]

The market provides a consensus price.

This would be a good assumption to take, maybe fifty plus years ago, when speculation wasn't as rife as it is nowadays (last I recall 80-90% of all trades on the market are/is speculation). I also want to mention that arbitrage, which is a measure to limit speculation is not as effective nowadays due to, well I'm not entirely sure what (would be a good thesis paper premise, probably due to most currencies being fiat based along with an overabundance of credit).

Basically, what I'm trying to say that the market isn't as rational as people think and more caution should be taken when making a long term investment.

 

[russ_watters]

[The market provides a consensus price.]
This would be a good assumption to take, maybe fifty plus years ago, when speculation wasn't as rife as it is nowadays (last I recall 80-90% of all trades on the market are/is speculation). I also want to mention that arbitrage, which is a measure to limit speculation is not as effective nowadays due to, well I'm not entirely sure what (would be a good thesis paper premise, probably due to most currencies being fiat based along with an overabundance of credit).

Basically, what I'm trying to say that the market isn't as rational as people think and more caution should be taken when making a long term investment.

I think you and Stephen are arguing against a definition/reality here. Nobody has to agree that the price of a stock they see in the newspaper is "good" or "correct", but it is, by definition, the consensus price.

If you offer to sell me something for $110 and I offer to buy it for $90, and we eventually make the trade for $100, $100 is the consensus price. It doesn't matter if you or I think we got ripped off, we made an *actual agreement*, an *actual transaction* at $100. That's what a "consensus" is.

 

[russ_watters]

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"!

I posted a graph of it before and used it as a simplistic measure, but I do agree with you that it can vary over relatively long periods of time -- and that doesn't even necessarily indicate the market is under or over-valued during those times. More importantly, that means there is no way to know since as V50 pointed out, the P/E ratio marries today's P with last year's E, but next year's P will be based on next year's E. So what to do? How about..."nothing"! It will work itself out.

 

[russ_watters]

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...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".

That is disappointed to hear, because I've given arguments in pretty much exactly that form. I feel like we're getting bogged down in irrelevant minutiae and as a result you aren't really responding to the answers to this discussion you started. I'll try to list them concisely so we can refer back to them by number:

1. Computer logic has to be the same as people logic because computers are programmed by people. Even if people learn to harness the computers and they spit out different answers that the humans decide they like/work better, causing the human logic to adjust, that's still humans adjusting human logic. So the starting premise of your question is a false dichotomy: adding [more] computers to the mix doesn't change anything in how the markets work. Actually, two:

2. People logic does change. So the idea that the logic is constant now and could change in the future (for better or worse) isn't valid because it already changes constantly (that's why the stock market goes up one day and down the next!). So adding [more] computers to the mix doesn't change the change.

3. HFT specific: short term logic and long term logic are fundamentally different and not competing with/dependent on each other. So computers used for HFT trading cannot change the long term returns of buy-and-holders.

4. Most directly: Given that in #1 and #2 I said that logic does change all the time, computers or not, doesn't that mean that if it changes a certain way that it can affect long term returns? No. Because one way or another, stock prices are based on the profits of the companies, whereas a logic change is a single event. A logic change this year can make a stock that rises at 8% a year rise more or less this year, but next year it will go back to that 8% growth rate if the earnings keep growing by 8% a year. This is a simple mathematical reality that I mentioned before, but if you're not seeing it I can show you in a table/spreadsheet how it works.

 

[Question_]

That is disappointed to hear, because I've given arguments in pretty much exactly that form. I feel like we're getting bogged down in irrelevant minutiae and as a result you aren't really responding to the answers to this discussion you started. I'll try to list them concisely so we can refer back to them by number:

1. Computer logic has to be the same as people logic because computers are programmed by people. Even if people learn to harness the computers and they spit out different answers that the humans decide they like/work better, causing the human logic to adjust, that's still humans adjusting human logic. So the starting premise of your question is a false dichotomy: adding [more] computers to the mix doesn't change anything in how the markets work. Actually, two:

2. People logic does change. So the idea that the logic is constant now and could change in the future (for better or worse) isn't valid because it already changes constantly (that's why the stock market goes up one day and down the next!). So adding [more] computers to the mix doesn't change the change.

3. HFT specific: short term logic and long term logic are fundamentally different and not competing with/dependent on each other. So computers used for HFT trading cannot change the long term returns.

4. Most directly: Given that in #1 and #2 I said that logic does change all the time, computers or not, doesn't that mean that if it changes a certain way that it can affect long term returns? No. Because one way or another, stock prices are based on the profits of the companies, whereas a logic change is a single event. A logic change this year can make a stock that rises at 8% a year rise more or less this year, but next year it will go back to that 8% growth rate if the earnings keep growing by 8% a year. This is a simple mathematical reality that I mentioned before, but if you're not seeing it I can show you in a table/spreadsheet how it works.

I don't think there have been any advancements in logic for a good while. I don't mean to be snarky but, what has affected the market equilibrium the most is the amount of cash supply and information, along with many many more participants in the market activity.

 

[russ_watters]

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.

Because it is an important and common error and:

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.

Since you stated directly that you don't have a mechanism to propose as to how computers might affect future returns (your real question), you leave us little choice but to speculate about your concern for you (which is one reason the discussion lacks focus). Since it is logically difficult to prove an open-ended negative, much of what we've done is propose individual hypotheses about how computers might affect future stock prices/investment returns and then try to follow the logic to see if the hypothesis pans out. Computers as active fund managers is one such hypothesis. Whether you agree with or care about any particular hypothesis someone else proposes to focus your question isn't in our ability to know in advance. The only way for this discussion to be better focused on your question is if you focus your question better. Because at this point there is quite literally nothing more to it than fear of the unknown.

 

[russ_watters]

I don't think there have been any advancements in logic for a good while. I don't mean to be snarky but, what has affected the market equilibrium the most is the amount of cash supply and information, along with many many more participants in the market activity.

Oh, I agree. I think it says something that over a very long period of time, through vastly different political, economic and technological climates, the market return and p/e ratio have returned to their historical averages.

That said, I *do* have some concerns about the long term viability of stocks as an investment vehicle - just not for the reason proposed.

 

[gleem]

For AI/computers in investing check this out.

http://www.cnbc.com/2017/06/16/ai-a...ibms-watson-is-getting-into-etf-business.html

So now we will have something to watch and evaluate.

 

[Vanadium 50]

Part Two (Part One will come later):

I am going to use the word rational to describe stock pricing based on the mechanism I describe above: i.e. if you had a choice of investing $X in the stock or $X in Treasuries, you would not pay a premium to select either side. Speculation can be either rational or irrational -if I believe that XYZ is going to turn around under new leadership, and I am more confident of this new leadership than the consensus, I should be willing to pay a higher price for it than the consensus. This is speculative, and it may be wrong, but it's not irrational.

In a sense 100% of long positions in any investment are speculative. Greg might not have bought his condo - or at least that particular condo - if he knew it would lose 30% of its value. I think when people complain of "speculation" they are really complaining about irrational speculation. Given that 70% of the market is owned by institutional investors, I believe that most decisions are rational. If it's true that 90% of the trades are pure speculation, it means that this 90% is going on between just that 30%. And so what if they are churning stocks among themselves?

There also seems to be the argument that the fact that stock prices are not (largely) static is a sign that their trading is irrational. Rational pricing is in relation to a safe investment. It would predict that P/E is inversely related to treasury yields. I was looking for a scatter plot, but all I could find is this:

As you can see, over ~50 years E/P and yields do track.

 

[gleem]

Treasureys are always considered a safe investment at least for the preservation of capital.. If the government fails everything fails.

 

[Stephen Tashi]

A further comment on whether the market price of a stock is a "consensus price":

Suppose company X has 99 shareholders that think 20$ a share is too low a price to sell their stock and one share holder who is pressed for cash and will sell his shares for $20 a share. Among the buyers of stocks suppose all but one of the potential buyers thinks $20 is too high a price to pay for a share of company X but there is one buyer who will pay that much. That one buyer buys shares from that one seller. The market price of the stock is $20 even though the majority of people who hold the stock or consider buying it disagree with that price.

In realistic market situation, things are not that extreme but the hypothetical example illustrates that market prices are not set by a broad consensus among shareholders and potential buyers. Market prices are set by the minority of buyers and sellers who agree to trade at the market price. (In fact if the index funds don't execute trades, they leave the market prices to be set by people like the much-despised day traders - people that actually execute transactions.)

 

[collinsmark]

The following will be elementary and obvious to most PF members reading this thread. But allow me give a brief, extremely basic and somewhat simplified tutorial on how stock market price is determined. I got the impression that there might still be some confusion as to how the market prices of stocks are determined.

Again, this is somewhat simplified, but the following image sums it all up:

Prospective buyers and sellers queue up in order based on their desired sell or buy price. Each person can instantly change their place in the queue (line) at any time merely by changing their desired sell or buy price. If those people at the front of each queue (line) agree on a price, the sale is made and that becomes the new market price. If those at the front of each queue do not reach a common price, a stalemate is reached; no transactions occur and the market price remains at the price it was when the last transaction occurred. Of course, this stalemate can alleviated at any time by someone jumping to the front of the line and making a transaction.

In reality, a slightly more detailed version than above, sales happen through brokers -- middlemen so to speak -- who handle the details of the transactions. A broker can be an automatic, online entity (e.g., Ameritrade, ETrade, etc.), it doesn't necessarily need to be a human.

• If you want to buy at a certain price, you can tell your broker to buy x number of shares if the market price ever falls to $y. If the market price ever actually does fall to $y that means that your order has reached the front of the queue where a transaction was made. It means that those that were in front of you in the queue either already bought or canceled their orders, and some seller was willing to sell at your buy price. Usually such orders are good for a certain time limit, typically 30 days.
  
• If you want to buy the shares immediately, you can tell your broker to buy them at market price. Your broker will put your order at the front of the queue and buy the stock at the front of the "sell" queue at whatever the lowest "put" price is.
• Similarly, if you have stock and want to sell x number of shares at a certain price, your broker can put your order in the queue at your specified "put" price. This order usually has a time limit, typically 30 days.
• And of course you can jump ahead in the queue and sell your stock at market price by telling your broker to sell at market. Your broker will then sell your specified number of shares to those at the front of the buyers' queue, at whatever price they have specified as their buy price.
• Whenever a transaction occurs, that determines the new, reported market price: it's whatever the price of the last transaction was.

So what happens if the price at the front of the sellers' queue is higher than the price at the front of buyers' queue (and nobody jumps to the front of either line)? Nothing. No transactions are made. The "market price" remains at what it was when then last transaction actually occurred. This isn't too uncommon in small-cap stocks, btw. It's not out of the ordinary for some very small-cap stocks to go for days or even weeks without a single transaction. And that means that the stock's reported market price remains constant throughout that time interval.

 

[russ_watters]

A further comment on whether the market price of a stock is a "consensus price":

Suppose company X has 99 shareholders that think 20$ a share is too low a price to sell their stock and one share holder who is pressed for cash and will sell his shares for $20 a share. Among the buyers of stocks suppose all but one of the potential buyers thinks $20 is too high a price to pay for a share of company X but there is one buyer who will pay that much. That one buyer buys shares from that one seller. The market price of the stock is $20 even though the majority of people who hold the stock or consider buying it disagree with that price.

I don't think that's physically possible because common trading procedures aren't set up to deal with such stupid requests, but in that case the consensus price is $20. Why are you bringing such a silly scenario into the discussion?

In realistic market situation, things are not that extreme but the hypothetical example illustrates that market prices are not set by a broad consensus among shareholders and potential buyers. Market prices are set by the minority of buyers and sellers who agree to trade at the market price. (In fact if the index funds don't execute trades, they leave the market prices to be set by people like the much-despised day traders - people that actually execute transactions.)

You're dancing around your own point: Yes, index fund owners don't execute many trades, so they don't set market prices, so they aren't "potential buyers", so they don't actively help form the consensus price*.

Again: The "consensus price" is the price you pay for a stock right now. And that doesn't just include the buyers and sellers, it also includes the holders*, who agree with the consensus by virtue of the fact that they have decided to hold at the current price.

And what bearing does this have on the question you raised about the potential for computer driven trading to impact market returns?

 

[Vanadium 50]

Why are you bringing such a silly scenario into the discussion?

This is my fault. I was trying to get everyone on the same page about the price of a security being a measure of its future income stream. I didn't anticipate we would get into a discussion about "what is price?"

 

[Stephen Tashi]

As you can see, over ~50 years E/P and yields do track.

I'm curious how an e/p ratio is computed for a stock index. For example, in the case of two companies with respective earings E1, E2 and respective prices (at some time? or averaged over some time?) P1, P2. Is the e/p ratio computed as (1/2) (E1/P1 + E2/P2) or as ( (E1 + E2)/2 ) / ( (P1 + P2)/2) = (E1 + E2)/ (P1 + P2) ?

Again: The "consensus price" is the price you pay for a stock right now.

it's as @collinsmark illustrates. The market price is the price at which some people buy and sell the stock.. The market price is not the "consensus" price that all buyers and sellers agree is appropriate.

And that doesn't just include the buyers and sellers, it also includes the holders*, who agree with the consensus by virtue of the fact that they have decided to hold at the current price.

People who don't trade disagree with the market price.

And what bearing does this have on the question you raised about the potential for computer driven trading to impact market returns?

I don't know. I myself haven't offered any argument that begins with the (false) assertion that the market price is a broad consensus of the value of a stock - and then proceeds to deduce that the advent of computer programs won't affect the long-term stock market.

 

[TeethWhitener]

I don't think that's physically possible because common trading procedures aren't set up to deal with such stupid request

This is absolutely possible, and is in fact exactly how a market order works. EDIT: Maybe it's the case that your broker won't let you set that kind of order, but if you're a market maker, you can offer any price you want. (Several trades along these lines popped up during the Flash Crash of 2010)

The idea of a "consensus" price as everyone's using it seems to be related to a concept called the efficient market hypothesis: the price of a security reflects all available information about that security. There are various schools of thought on how efficient the market actually is, and most of the evidence points toward "pretty efficient," which is borne out in the observation that most actively managed funds don't beat the indexes. But some very famous people (e.g., Warren Buffett and other value investors) have made a name for themselves working with the notion that individual securities in the market can be long-term mispriced, such that if you can identify a truly undervalued stock, you can beat the market as that stock's price reverts to a true reflection of the asset's underlying value.

I'm curious how an e/p ratio is computed for a stock index.

Different indexes compute them differently. Some weight the stocks, some don't include companies with negative earnings, some do the Shiller PE (averaged over 10 years to smooth out fluctuations from the business cycle). Generally people just go straight to the indexing company for their calculation of PE.

Changing topics: One thing that I've been thinking about lately that I simply don't know that much about is why the P/E ratio is what it is. Not in the sense that it's price divided by earnings, but specifically why is it that we consider a "normal" P/E to be ~15 or so. What's the underlying cause for the number, other than "that's what it's been historically?" The number seems to indicate that if you invest $1 in a random stock, you can expect to sell the stock for $15 at some point in the future. Assuming the stock market goes up ~10%/year, the time to double is ~7 years, so the time to get to 16x is ~28 years. So very roughly, 15x is the expected return on a random stock after a ~30 year investment window. This seems anthropically appropriate, if you consider investing as a 30-something year old and selling assets as a 60-something year old, but this gave me an interesting thought. The PE for the broad market is currently at ~25 and has been creeping up for a few decades. Under an efficient market, this would happen because we expect higher future earnings from the market. Higher future earnings imply (again assuming efficient market) either more productive companies or a longer time horizon. So is the market anticipating a future of glorious hyperproductivity, or just sensing that people in the future will retire much later than age 65? (Of course in all likelihood, the real answer is that the market isn't perfectly efficient and the price is just evidence of a bubbly market).

 

[NTL2009]

Actually index funds being traded like stocks can be bid up/down if buyers/sellers feel the market will rise or fall say for example for a good or bad jobs report or interest rate increase.
...
A current price is very actionable. you can sell or short it if you think it is too high or buy more if you think it is a bargain.

And for long term personal investors, it doesn't matter. Sure, the price will move around based on day-to-day noise, and none of us can know which price reflects the "true" long-term value. But a personal investor will make many buys over their accumulation phase (normally through a payroll deduction, or other regular purchase program), so all this averages out.

This is not directed at you gleem, but I thought this thread was about "PF Investing" - IOW, what the normal type of person frequenting this forum should pay attention to regarding personal finance decisions.

Instead, it seems to have turned into some esoteric discussion of the value of a stock or fund - something maybe better discussed in an advanced review of the science of Economics?

Heck, my Father was a salt-of-the-earth type, barely had a high school education, but did well for himself and his family. One of the things he told me "Something's only worth what someone else will pay you for it". Forget the rest of the discussion, that's where the rubber meets the road, and no PhD in Economics can really add anything meaningful to that for the average investor.

 

[NTL2009]

This is absolutely possible, and is in fact exactly how a market order works. EDIT: Maybe it's the case that your broker won't let you set that kind of order, but if you're a market maker, you can offer any price you want. (Several trades along these lines popped up during the Flash Crash of 2010) ...

No, not in the world of how the personal investor should be approaching things. The personal investor should be investing in highly liquid, broad-based, low cost, index funds. The reality is (theoreticals don't matter to us 'regular folk'), none of us is likely to place an order large enough to move the market of a large fund. The spread on a highly liquid ETF is tiny, and averages out over time. Just buy/sell as needed.

If you were to look at not just the bid/ask, but the depth and volumes of the bid/ask on an ETF like SPY, you'd find more than enough sellers to fill your order within a penny or two. Pennies are not make/break for a long term investor. There is no big delta to be concerned with. If some investor is holding out for 2x of the current price, it doesn't matter to me, because someone else will fill my order within a tenth of a percent of the current price.

The idea of a "consensus" price as everyone's using it seems to be related to a concept called the efficient market hypothesis:

No, not 'everyone'. Several of us are saying (over and over again), that it just "is", efficient or not, high, low, middlin' or not. It is what it is. I'll repeat what my father taught me "Something is only worth what someone will pay you for it". Period.

But some very famous people (e.g., Warren Buffett and other value investors) have made a name for themselves working with the notion that individual securities in the market can be long-term mispriced, such that if you can identify a truly undervalued stock, you can beat the market as that stock's price reverts to a true reflection of the asset's underlying value.

I am not Warren Buffet. I doubt any of us are. I believe (not sure, correct me if I'm wrong) that Warren Buffet also got involved in the management of those companies, not simply a passive investor. And here is what Buffet says :" Buffett is skeptical that active management and stock-picking can outperform the market in the long run, and has advised both individual and institutional investors to move their money to low-cost index funds that track broad, diversified stock market indices."

Changing topics: One thing that I've been thinking about lately that I simply don't know that much about is why the P/E ratio is what it is. Not in the sense that it's price divided by earnings, but specifically why is it that we consider a "normal" P/E to be ~15 or so.

Well 1/15 ~ 6.7%. I think it only means that on average, we expect annual earnings to be somewhere around 6.7% of the stock price. No guarantees of course, but I think historically, over the long run, entrepreneurs on average won't work for less (or won;t get funded for less). And the ones that don't earn near that eventually fail to compete with 'risk free' investments like Treasuries. And when they make far more than 6.7%, competitors come into that market for a piece of that sweet action, and it rarely lasts long. It's kind of like the equilibrium states we find in nature.

 

[TeethWhitener]

No, not in the world of how the personal investor should be approaching things. The personal investor should be investing in highly liquid, broad-based, low cost, index funds. The reality is (theoreticals don't matter to us 'regular folk'), none of us is likely to place an order large enough to move the market of a large fund. The spread on a highly liquid ETF is tiny, and averages out over time. Just buy/sell as needed.

If you were to look at not just the bid/ask, but the depth and volumes of the bid/ask on an ETF like SPY, you'd find more than enough sellers to fill your order within a penny or two. Pennies are not make/break for a long term investor. There is no big delta to be concerned with. If some investor is holding out for 2x of the current price, it doesn't matter to me, because someone else will fill my order within a tenth of a percent of the current price.

Maybe you meant to reply to someone else. This has nothing to do with what I posted. I was specifically replying to Russ Watters, clarifying the technical details of what exactly happens when a "regular folk" submits an order through their broker.

No, not 'everyone'. Several of us are saying (over and over again), that it just "is", efficient or not, high, low, middlin' or not. It is what it is. I'll repeat what my father taught me "Something is only worth what someone will pay you for it". Period.

"Consensus" is generally construed to mean "broad agreement." Your position implies that the word "consensus" is superfluous. Why say "consensus price" instead of just "price?"

And here is what Buffet says :" Buffett is skeptical that active management and stock-picking can outperform the market in the long run, and has advised both individual and institutional investors to move their money to low-cost index funds that track broad, diversified stock market indices."

In this case, Buffett was specifically referring to hedge funds which charge ridiculous fees and take a percentage of the gains. These fees can soar to effectively 15-20% of an entire portfolio. He made a bet that they couldn't beat the indexes, and he was right. Buffett himself has always been a staunch supporter of the Graham-Dodd school of value investing (Ben Graham was his advisor at Columbia), which explicitly rejects the efficient market hypothesis. Others have argued that his gains have largely been outsized beta with clever use of leverage, rather than pure alpha, (which may or may not be true) but his personal outlook--as far as I can tell--has always been as a value investor.

Well 1/15 ~ 6.7%. I think it only means that on average, we expect annual earnings to be somewhere around 6.7% of the stock price. No guarantees of course, but I think historically, over the long run, entrepreneurs on average won't work for less (or won;t get funded for less). And the ones that don't earn near that eventually fail to compete with 'risk free' investments like Treasuries. And when they make far more than 6.7%, competitors come into that market for a piece of that sweet action, and it rarely lasts long. It's kind of like the equilibrium states we find in nature.

I think you're probably right; this is a better way of thinking about it. In this case, the rising PE ratio that we observe simply reflects the fact that a rock-bottom treasury rate pushes more people into stocks as they go yield hunting, thus driving down returns.

 

[jtbell]

The spread on a highly liquid ETF is tiny, and averages out over time. Just buy/sell as needed.

The average bid/ask spread on the big Vanguard index ETFs that I use (Total Stock, Total International Stock and Total Bond) is at most 0.02% (ref: Vanguard web site). On $10K worth of trades, that's about $2. Not enough for me to even think about. On the handful of trades that I make in a year, I use market orders.

 

[Stephen Tashi]

The average bid/ask spread on the big Vanguard index ETFs that I use (Total Stock, Total International Stock and Total Bond) is at most 0.02% (ref: Vanguard web site). On $10K worth of trades, that's about $2. Not enough for me to even think about. On the handful of trades that I make in a year, I use market orders.

Who are the "authorized parties" for creating (or liquidating) additional shares of the Vanguard ETFs? (My guess would be that they are some department within Vanguard.)

 

[NTL2009]

Maybe you meant to reply to someone else. This has nothing to do with what I posted. I was specifically replying to Russ Watters, clarifying the technical details of what exactly happens when a "regular folk" submits an order through their broker. ...

Sorry, maybe the string of quoting got confusing, but I'll stand by what I said. There's plenty enough depth in the bid/ask of the big index funds for the size order any of us might place.

"Consensus" is generally construed to mean "broad agreement." Your position implies that the word "consensus" is superfluous. Why say "consensus price" instead of just "price?" ...

I'm staying out of any further "consensus" discussion, I don't see the value to personal investment in picking this word apart. Place an order for a big index fund/ETF - you will be filled near immediately, and often somewhere between the current bid/ask.

NTL2009 said: ↑
And here is what Buffet says :" Buffett is skeptical that active management and stock-picking can outperform the market in the long run, and has advised both individual and institutional investors to move their money to low-cost index funds that track broad, diversified stock market indices."

In this case, Buffett was specifically referring to hedge funds which charge ridiculous fees and take a percentage of the gains.

While he certainly includes hedge funds in this, I really don't think he was referring only to them.

https://finance.yahoo.com/news/warren-buffett-best-investing-advice-201019702.html
Bold mine:

If you are a professional and have confidence, then I would advocate lots of concentration. For everyone else, if it’s not your game, participate in total diversification. The economy will do fine over time. Make sure you don’t buy at the wrong price or the wrong time. That’s what most people should do, buy a cheap index fund, and slowly dollar cost average into it. If you try to be just a little bit smart, spending an hour a week investing, you’re liable to be really dumb.

 

[Stephen Tashi]

Averaging-in to an investment has been discussed. What are the problems of averaging-out ?

If life behaves nicely we can gradually sell our shares for cash and gradually spend it or put it in a bank. If we have a flexible goal like "Buy a house within the next 3 years" , we can watch the market and cash-in all at once at a satisfactory time.

However, life being the way it is, many accounts will get cashed-in because of some unexpected need for cash or the death of the account holder.

I'm curious how an account is valued when the account is closed due to death. (If you don't want to think about your own death, you can think about how you would advise someone that you expect to inherit from.) In particular, how is the value of the account calculated when it is closed out. Is it calculated on the date of death of the account holder? - or the date when the manager of the account is notified of the death? - or the date when the account manager gets around to closing the account? - or in some other legally mandated way?

I only know how (USA NM) bank accounts are handled. Joint accounts remain open if one account holder is still alive. Accounts owned only by the deceased are frozen. If transfer-on-death beneficiaries have been declared, the account is closed and the funds are distributed to the beneficiaries. If no beneficiaries are declared, the court appointed executor can withdrawn the funds from the frozen account, but he cannot re-open it. (Of course he has the option of opening an new account in the name of the estate.)

There are no conditions where a bank account with a single deceased owner can be re-opened and transferred to a new owner. Is that how accounts with brokers and mutual funds work? When my father died, there was no option for the heirs to take over his mutual fund accounts. They had to be closed out. But that was many years ago.

 

[NTL2009]

Averaging-in to an investment has been discussed. What are the problems of averaging-out ?

I'd need to refresh myself with some credible sources, but I believe (and it makes sense) that DCA out has some negatives that offsets some of the benefits of DCA in. OK, consider that the market is generally rising over the long term, so the money you took out early didn't have a chance to grow. And on a dip, if you take out a set $ amount each time period, you have to cash in more shares to do it, so fewer shares to grow - yep, seems like a mirror image of the DCA in thought process, right?

But we don't really have a choice if we need that money to fund our retirement. I guess the lesson is to not sell until you need it? But it isn't really too big a deal, if you are conservative in your withdrawal plan, a retirement portfolio will kick off enough dividends to fund most of your planned expenses, so there isn't much selling to do. For example, SPY provides ~ 2% in divs, and BND ~ 3%, so 50/50 Asset Allocation and you've got 2.5% in divs. If you need 3.5% to live on, you sell ~ 1 % a year. There are some calculators that can illustrate this, with historical market data. Here's a very flexible one that I like:

http://www.cfiresim.com/

(Full, but unnecessary disclosure - I did some alpha-beta-testing and encouragement for the developer, and had some UI input, but I have no financial connection at all). It is a reverse engineered version of firecalc.com which hasn't had any code improvements in many years, which was the motivation to create a reverse engineered version of it.

I'm curious how an account is valued when the account is closed due to death. (If you don't want to think about your own death, you can think about how you would advise someone that you expect to inherit from.) In particular, how is the value of the account calculated when it is closed out. Is it calculated on the date of death of the account holder?

Normally the value of the account (and therefore the cost basis) is calculated at the date of death. I recall a variation that is acceptable, I think under certain conditions, the executor can pick a date within 6 months, or something? I would have to google it.

The importance of the cost basis (called a 'step-up') in basis is, if this person held a stock (or land, or any thing with capital gains) for many years, say they bought it it for $1,000 and now it is worth $101,000. If they sold while alive, they'd owe cap gains (probably 15%) on $100,000 of gain. But if you inherit it, it is 'stepped up' to its current $101,000 on your books. So if you sell it at that price, you owe no cap gains tax. So it pays to be extra careful to cash in the stuff with low/no cap gains late in life, if you are able to pass appreciated capital to your heirs (instead of dear old Uncle Sam)

When my father died, there was no option for the heirs to take over his mutual fund accounts. They had to be closed out. But that was many years ago.

I helped my wife's family with this when my father-in-law passed, and a bank is handling my Mother's estate. What I've seen, an EIN is assigned to the deceased to replace their SSN. Any accounts that were left in their name must be re-titled to this new EIN.

It's important to make sure things like IRAs and insurance policies have a beneficiary assigned, and that it is current. Any account with a named beneficiary, or Transfer on death, or in a trust with named beneficiaries, etc, does not go through probate. Probate is to make sure things get divided correctly, and the names on the other types of accounts make this clear, and a bank won't release them to anyone else anyway, so no other controls are needed.

Much of this can vary by State (here in the USA), so do your own due diligence. The NOLO series of books are a very good reference for this.

 

[Stephen Tashi]

The stepped-up basis is a great simplification for the executor of an estate (although there may be some strings attached for multi-millon dollar estates). The stepped-up basis also applies to houses, antiques, etc. The executor can sell such property for cash without worrying about what price the deceased originally paid for the property - provided the value of property is about what it was when deceased died. The sale is not considered a capital gain. It's just a change of assets from one form to another.

Declaring transfer-on-death beneficiaries for financial accounts is a convenience if the beneficiaries need funds immediately. People can incur travel expenses and loss-of-work when a relative dies. Things like funeral expenses, cleaning expenses, shipping expenses can come up before an estate exists as a legal entity.

However, it's good to leave some funds to the estate. Otherwise the executor has no money to deal with expenses.

An interesting feature of transfer-on-death is (in NM, USA) that the declared beneficiaries of a CD don't roll over when a CD rolls over. In a situation I'm dealing with, this had the fortunate effect of leaving some funds in the bank for the estate to take over.

The USA IRS will issue an EIN number to an estate. This is a simple procedure and can be done online by a person who declares he is an executor or otherwise legally entitled to manage the estate. This isn't the same as changing the deceased's tax-ID to an EIN. Without an EIN number, a bank won't open an account for the estate. The estate files taxes on behalf of the deceased if any became due before the person died. After that, the estate files taxes only on behalf of itself.

An interesting question is what happens when a check made out to the deceased (instead of his estate) arrives. In my experience, if the deceased has a joint account somewhere, it will remain open and the check can be deposited in that account. Once the estate exists as a legal entity and has a bank account, I've found that the bank is willing to deposit such checks. However, if all the deceased bank accounts have been frozen and the estate has not been legally set-up and opened its own account, there is nothing that can be done with such checks except to hold on to them.

 

[Vanadium 50]

I'm curious how an e/p ratio is computed for a stock index

The index price is the dot product of a vector of prices with a vector of weights. The index earnings are a dot product of the vector of earnings with the same vector of weights. The index P/E is their ratio. E/P is the reciprocal of that.

The market price is not the "consensus" price that all buyers and sellers agree is appropriate.

That does not exist. Before we got off on the what is "price" tangent, I explained that different people will differ on what they expect future earnings to be, and they will therefore value securities differently. This is true even for "safe" investments. Treasury rates are determined by auction.

 

[Vanadium 50]

One thing that I've been thinking about lately that I simply don't know that much about is why the P/E ratio is what it is. Not in the sense that it's price divided by earnings, but specifically why is it that we consider a "normal" P/E to be ~15 or so. What's the underlying cause for the number, other than "that's what it's been historically?"

As mentioned before P/E of 15.66 is about 6.4% annually. Historically, 30-year Treasuries have been at 4.7%, so one could argue that this extra 1.7% is what companies have to pay to compensate their investors for the additional risk. Lately, Treasuries have been closer to 3.9%, so insofar as things are linear, one would expect, everything else being equal, P/E should rise to about 18.

 

[Vanadium 50]

"Consensus" is generally construed to mean "broad agreement."

This is rapidly becoming isomorphic to "why do we use m for slope?"

I don't know why economists use the words they do. I imagine in this case it's because there is a consensus between at least one buyer and at least one seller that a trade should be made at this price. But for the sake of communication, I suggest we use the definitions rather than quibble about them. And yes, it would have been better had we defined electrons to have positive charge.

The more important point was the one farther down - today's price of a security reflects its future income stream.

 

[Vanadium 50]

What are the problems of averaging-out ?

In general, you would take money out only when you need it. If you "average" out, you're taking money out that you don't need, and presumably it goes into your bank. So the net effect is to rebalance your portfolio in a more cash-heavy direction. That may or may not be a good idea, but it should probably be judged on its own merits, rather than by the clock.