PF Investing Club: The Stock Market & Compounding Interest

[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.

 

[TeethWhitener]

I don't know why economists use the words they do.

I don't think economists use the words "consensus price." They use "consensus estimate" which refers to the consensus expected earnings for a company over a suitable time period. They also use "consensus price target," which refers to the price they expect the stock to be listed at after a suitable time period. But I've never heard economists using the phrase "consensus price."

Just so we're clear, the actual market price of a stock is set by competition between market makers. Stocks are not bought and sold directly between traders. So for example, market maker A offers to buy a block of 100 shares of XYZ for $10 (bid price) or sell a block of 100 shares of XYZ for $11 (ask price). Currently the bid-ask spread is at $1. If one trader wants to buy 100 shares for $11/share and another trader wants to sell 100 shares for $10/share, the market maker facilitates the sale and makes a small profit of $100 (#shares multiplied by bid-ask spread). If there is no or low demand for this transaction, the bid-ask spread will stay pretty large. Now let's say that something happens to company XYZ and all of a sudden traders want to exchange a million shares. Now all of a sudden, the potential profit at the $1 bid ask spread is $1M. This nice chunk of change catches market maker B's eye, who undercuts market maker A by offering to buy for $10.25 and sell for $10.75. Now the potential profit for market maker B is only $500k, but B is more likely to complete the sale than A. In order for A to make any money, he has to outcompete B. Thus liquidity demand drives lower bid-ask spreads.

That said, any market maker can offer any price they want. (NB--I don't know what the full regulatory rules are, so this might not strictly be true, and at any rate, it certainly depends on your jurisdiction) If market maker C comes along and offers to buy for $11 and sell for $10, guess who all the traders are going to flock to. But C has no economic incentive to do that.

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

Sure. That's uncontroversial. I also understand and respect the impetus to leave the thread at basic personal investing advice. But I doubt it hurts to know a little bit about how the market actually works.

 

[collinsmark]

'Bit of humor for the day:

(Source: http://www.smbc-comics.com/comic/regression)