PF Investing Club: The Stock Market & Compounding Interest

[Greg Bernhardt]

This thread was spawned off
https://www.physicsforums.com/threads/financial-knowledge-all-adults-should-know.916758/

Do not act on any financial advice here before doing due diligence and meeting with a qualified financial advisor.

The stock market. It isn't called "interest", but the principle is the same.

hmmm I guess I am missing something. If I buy 1 share for $10 and if over a few years it goes up by 10% then I have $11. Where is the compounding?

 

[Vanadium 50]

So let's take a look at that. The worst decade for stocks was 1928-1938, with an annual return of -1.3%. This is the only 10-year period in the history of the Dow where the return was negative. The worst 20-year period (1928-1948) had an annual return of 2.5%. The worst 35-year period (1906-1941) had an annual return of 6.1%. The worst 50-year period was (1928-1978) had an annual return of 6.8%.

So the risk you have with buying stocks, and as you see, there is risk, is reduced the longer you own it. Furthermore, most people don't buy stocks all at once and hold them for decades. They buy continuously. That also reduces risk - when stocks go down, you buy more shares for the same money, and when they go back up, you realize more gains because you have more shares. This goes by the name of dollar cost averaging. It also shows that stocks are risky if you need the money a year or two down the road.

Low cost index funds, with dividend reinvestment (the equivalent of compound interest for an instrument that doesn't exactly produce interest), are a simple and diversified way to take advantage of this. Vanguard 500, for example, mirrors the S&P 500 for an expense ratio of 0.14% - that is, you need to drop those rates of return by 0.14% to cover the fees. So 6.1% becomes 5.96%. This particular fund has an initial investment requirement of $3000. This may seem like a lot, but if you don't have $3000, your first priority should be to beef up your savings. You need a safety net now more than you need returns down the road.

 

[Vanadium 50]

Where is the compounding?

The stock likely paid dividends. If you reinvest them, there's your compounding.

 

[russ_watters]

hmmm I guess I am missing something. If I buy 1 share for $10 and if over a few years it goes up by 10% then I have $11. Where is the compounding?

The $11 is your new principal and the growth is calculated against that new principal annually. You don't gain 8% of your original investment per year, you gain 8% of your current principal per year.

 

[Greg Bernhardt]

The $11 is your new principal and the growth is calculated against that new principal annually. You don't gain 8% of your original investment per year, you gain 8% of your current principal per year.

Are we talking the market as a whole or for individual stocks? Looking at my positions with the stocks I own I don't see this as the case. Perhaps I should just go into the Vanguard 500 where I'll be given 6-8% on average and then see compounding.

 

[russ_watters]

Are we talking the market as a whole or for individual stocks? Looking at my positions with the stocks I own I don't see this as the case. Perhaps I should just go into the Vanguard 500 where I'll be given 6-8% on average and then see compounding.

As a whole (S&P 500 is good), the average is about 8%. As V50 said, the WORST it has ever done over a retirement account span of time (50yrs) is 7% per year.

 

[Greg Bernhardt]

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?

 

[Vanadium 50]

the WORST it has ever done over a retirement account span of time (50yrs) is 7% per year.

But the best (1949-1999) is only 12.8%. Long period investing reduces the risk of losing your shirt, but it also reduces the chances of a windfall. Something called a diversification return (analyzed in some detail by physicist Scott Willenbrock) helps with this.

Greg, the way this "compounding" works is suppose you bought your stock at $10. The next year it's at $9, the year after that, $12. Then $11, and so on, and after 20 years it's at $67. That works out to a 10% average rate of return because (1+10%)^20 = 67/10. It's an equivalent compound interest for an instrument that doesn't really have interest. There is an expectation that this will happen at some level for a profitable corporation. The company either pays a dividend, which you then reinvest (like compound interest) or the company re-invests the profit within the company, which is essentially the same as a reinvested dividend.

 

[Greg Bernhardt]

The company either pays a dividend, which you then reinvest (like compound interest) or the company re-invests the profit within the company, which is essentially the same as a reinvested dividend.

Interesting! That makes sense to me, thanks! So, in a way growth stocks are riskier because you are betting they use your "dividend" wisely.

 

[Vanadium 50]

So hold tech giants for 30 years or Van500?

Most of Amazon and Google's growth has already happened, so you shouldn't expect historical returns from them. Putting money in only two companies has inherent risk to it - there were times when WorldCom, Enron and WaMu looked like great deals (and Theranos would have too, had they been public). Now, not so much. What you would really like to do is to have invested in Amazon or Google when they were smaller. Can't do that, but maybe you can do that for the next Amazon.

One way to attempt that is to invest in smaller cap stocks, for example, the Russell 2000 index. The idea is that before Google was a big company, it was a small company, so investing in many small companies is a way to capture some of this growth, and by investing in many reduces the risk. Conventional wisdom is that the Russell 2000 has slightly better returns than the S&P 500, but is slightly more volatile and thus slightly more risky.

My strategy has been to avoid trying to strike it rich, and get steady, decent returns year in and year out.

 

[strangerep]

Looking at my positions with the stocks I own I don't see this as the case. Perhaps I should just go into the Vanguard 500 where I'll be given 6-8% on average and then see compounding.

I get the feeling you could benefit from reading more about low-cost diversified index funds. Vanguard offers quite a lot of literature on this if you look on their website. I've been invested with them for many, many years, but there are now quite a few other funds of this type, including so-called ETFs (exchange-traded funds).

When planning a long term portfolio, the most important thing is to set your proportions of asset classes correctly for your investment timeframe. E.g., if you're only invested in stocks (whether US-based or international), that's still really just 1 asset class. The main other asset class is bonds. (Maybe property as well, but that's far less liquid, hence hard to trade unless you use a listed property investment fund, but those tend to behave more like shares than property.) I.e., focus on broad asset classes, not individual stocks/bonds.

For examples of this, take a look at Vanguard's diversified funds -- not just their stocks-only, or bonds-only funds. For a long term (retirement-like) strategy, and minimum rule-of-thumb is to take your age, and have no more than that (as a percentage) in income assets (with the rest in income assets, i.e., bonds). So a young person should be in a high-growth fund, whereas an old person should be more weighted towards income assets.

Btw, Vanguard's diversified funds invest in major markets all over the world, so that gives an extra degree of diversification. They use "passive investing" -- meaning that when one asset class starts to become valued higher than its target percentage range in the fund, they sell some of those assets and buy other lower-valued asset classes. Hence they achieve an automatic mechanism of sell-high/buy-low just by rebalancing their portfolio asset class proportions. A similar thing can be done using the ordinary cash flow through the fund. The beauty of this is that you don't need to rely on expert stocking picking.

 

[Astronuc]

Investopedia has a good article on comparing ETFs. One should looks at fees.
http://www.investopedia.com/article...-vs-russell-2000-etf-which-should-you-get.asp
http://www.investopedia.com/articles/investing/040516/10-cheapest-vanguard-etfs-voo-vti.asp

On individual stocks, one should look at P/E and EPS, as well as the overall market and sectors, i.e., do one's homework.

One can look at dividends and/or appreciation potential. With good dividends of a few percent or more, once can do dividend reinvestment.

 

[Greg Bernhardt]

Found this article written just a couple weeks ago, touting Van500
http://www.cnbc.com/2017/06/14/index-funds-are-the-smartest-way-to-invest-your-money.html

 

[Imager]

@Vanadium 50,

Excellent comments. Most of the staff in Finance Departments that I have worked in could not have explained things so well!

 

[kyphysics]

This thread was spawned off
https://www.physicsforums.com/threads/financial-knowledge-all-adults-should-know.916758/

Do not act on any financial advice here before doing due diligence and meeting with a qualified financial advisor.hmmm I guess I am missing something. If I buy 1 share for $10 and if over a few years it goes up by 10% then I have $11. Where is the compounding?

Hey, Greg

Are you proposing a thread for any and all things investing related in the OP? Or, is this thread devoted to some very specific questions/issues (raised in my other thread)?

I'd love to have a one-stop-shop type of thread for all investing chat. It'd be fun and education, as I'm just getting started and learning. Count me in if it's an investing mega-thread!

 

[Vanadium 50]

Strangerep mentions diversification. He's right, but I think that opens up an even more fundamental question: "When do you need the money?"

If I needed the money next year, I sure wouldn't put it in stocks. Sure, the average return is maybe 10%, but there are some horrible negative outliers. A 1 year treasury would get me 1.22%. I can probably find a 1.25% CD- whether that's better or worse depends on your state's income tax. I'd definitely go for that over buying a mutual fund, and especially over buying a single stock.

This in turn brings up the concept of risk. At it's core, investing is about maximizing return for a given amount of risk (or equivalently, minimizing risk for a given return). If I need a $10,000 a year from now, investing $9900 in a CD today has less risk than investing $9000 in Amazon today. As an investor, it's my job to decide if the reduced risk is worth the $900. This is where diversification comes in - it's a key tool in adjusting risk.

 

[jtbell]

I'd invest in low cost index funds if I had the money.

But how do those generate compound interest?

Reinvested dividends. The Vanguard Total Stock Market Index fund currently yields about 1.8% in dividends. Vanguard Total Bond Market currently yields about 2.3%. With a stock fund you also have capital appreciation (increase in share price), which of course varies a lot and is negative in some years.

 

[jtbell]

Perhaps there are some stocks with nice dividends, but even then you need a lot of shares to make it worth it.

Dividends are not "free money." A company's profits can be either distributed to shareholders as dividends, or reinvested in the company, which tends to increase the stock price, or held as cash reserves, which also tends to increase the stock price. For investors, this produces a tradeoff between dividends and capital gains. This isn't easy to see with individual stocks because of the normal random variation in stock prices. However, if you compare an index fund that "specializes" in high-dividend stocks with a total market index fund:

This is a "growth chart" that starts with $10K of each fund, and assumes dividends are reinvested.

The dark blue line is Vanguard Total Stock Market Index (VTSMX), which currently yields about 1.8% in dividends. The yellow line is Vanguard High Dividend Yield Index (VHDYX) which currently yields about 3.0% in dividends. How much difference do you see? And when they are noticeably different, which one comes out on top?

 

[Greg Bernhardt]

Are you proposing a thread for any and all things investing related in the OP? Or, is this thread devoted to some very specific questions/issues (raised in my other thread)?

I'd love to have a one-stop-shop type of thread for all investing chat.

Any type of specific investing questions or commentary, not just general financial advice as the other thread is about.

 

[kyphysics]

Reinvested dividends. The Vanguard Total Stock Market Index fund currently yields about 1.8% in dividends. Vanguard Total Bond Market currently yields about 2.3%. With a stock fund you also have capital appreciation (increase in share price), which of course varies a lot and is negative in some years.

Is that technically compounding, though?

Also, you're right that you can lose money too! Although, index funds or slow growth funds/stocks are "safe."

Here's a question:

Assuming your non-stock market financial situation is solid (you have a decent stable income, low to zero debt, no crazy liabilities, etc.), is there any reason to not reinvest dividends in a good fund/stock?

 

[Imager]

is there any reason to not reinvest dividends in a good fund/stock?

Keeping track of them for tax purposes, but that doesn't apply to 401ks, IRAs, etc.

 

[guigabyte]

I'd recommend looking into buying into some cryptocurrency like ether or bitcoin. Even though they are very volatile many believe there is huge room for growth. I personally believe the etherium protocol is great and I think it will grow.

 

[jtbell]

is there any reason to not reinvest dividends in a good fund/stock?

Keeping track of them for tax purposes, but that doesn't apply to 401ks, IRAs, etc.

Yep, if you automatically reinvest dividends in a taxable account (i.e. not a 401K, IRA, etc.), it's tedious keeping track of the "cost basis" for when you eventually sell. (You pay income tax only on the gains, not on the total proceeds of a sale of stocks or mutual funds.) If you're purchasing new shares regularly anyway, you can take the dividends as cash and add the cash to your regular purchases so as not to create extra "tax lots" of shares.

However, I think for most people who are accumulating money for retirement, that money should go first into tax-deferred accounts. When you sell, you pay tax on the whole proceeds, so cost basis isn't an issue. (The tradeoff is that you don't pay tax on the money that you put into those accounts.) You can contribute up to $5500 per year to IRAs, plus up to $18000 per year in a 401k or 403b if you have one available at work. Most people have to make a lot of money before they can "max out" both contributions and have leftover money for a taxable investment account.

 

[kyphysics]

Yep, if you automatically reinvest dividends in a taxable account (i.e. not a 401K, IRA, etc.), it's tedious keeping track of the "cost basis" for when you eventually sell. (You pay income tax only on the gains, not on the total proceeds of a sale of stocks or mutual funds.) If you're purchasing new shares regularly anyway, you can take the dividends as cash and add the cash to your regular purchases so as not to create extra "tax lots" of shares.

However, I think for most people who are accumulating money for retirement, that money should go first into tax-deferred accounts. When you sell, you pay tax on the whole proceeds, so cost basis isn't an issue. (The tradeoff is that you don't pay tax on the money that you put into those accounts.) You can contribute up to $5500 per year to IRAs, plus up to $18000 per year in a 401k or 403b if you have one available at work. Most people have to make a lot of money before they can "max out" both contributions and have leftover money for a taxable investment account.

Would the stock/fund holder have to do that or would an accountant (well-paid) do that work (just plop down all your statements on their desk and say, "have fun")?

 

[Vanadium 50]

I'd recommend looking into buying into some cryptocurrency like ether or bitcoin. Even though they are very volatile many believe there is huge room for growth. I personally believe the etherium protocol is great and I think it will grow.

This is gambling, not investing.

 

[jtbell]

Would the stock/fund holder have to do that or would an accountant (well-paid) do that work (just plop down all your statements on their desk and say, "have fun")?

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).

 

[Imager]

My opinion, a beginning investor should write down why they made each purchase. When you sell or ever year, look at the why’s. Use this as tool, to judge if your “whys” are good or bad, or at least if you’re investing on feeling or thinking.

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.

 

[Charles Kottler]

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.

For most people, getting started is the problem. Most people struggle to build even a modest amount of savings - to accumulate 3 to 9 months of salary in an account earning next to no interest would take many years. A more realistic approach is to pick a sum you can afford to spend on a regular basis say $10 - $100 p/w and use this for a regular investment into a managed or tracking fund over a 'fixed' period - pick a target of say 10 or 15 years. Small regular payments are quickly absorbed into your budgeting and go unnoticed. Having this money in a fund rather than a savings account makes it harder (but not impossible) to withdraw an will leave you with a good lump sum at the end of your chosen period.

 

[russ_watters]

Sorry for late reply...

Amazon and Google are obviously giants, but they now have extremely steep prices.

If you mean share price, don't look at it in isolation -- it's an arbitrary number that some companies choose to keep bite sized and some don't. The P/E ratio is pretty high on Amazon though (181).

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?

Depends on your risk tolerance. Tech stocks are probably still subject to bubbles more than the market as a whole, but some of the now more established companies look to be juggernauts for a while, but it is really tough to project where tech is going to be in 30 years.

I do own a little bit of Amazon and Facebook, but the vast majority of my money is in S&P500 index funds.

 

[russ_watters]

I'd recommend looking into buying into some cryptocurrency like ether or bitcoin. Even though they are very volatile many believe there is huge room for growth. I personally believe the etherium protocol is great and I think it will grow.

Currency is supposed to be stable to be useful, so there's a self-contradiction in it that makes it seem unlikely to me to be a good idea to consider it an "investment". Also, given its nature and history, I believe it to be highly subject to fraud and possibly even subject to being shut-down by governments.

 

[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.