Monday, August 1, 2016

When everyone invests passively...

I don't think the idea that the world (or, millennials?) are moving towards low cost passive investment needs much explanation. It's a given. What's interesting to me but I never see discussed is what happens when this trend is taken to its natural conclusion with everyone - or at least a major bulk of invested wealth - becomes passive.

Super Brief Primer on How Stocks are Priced
Imagine there's a stock and a universe of 10 investors. To make it easy, imagine right now all 10 own 10% each of the available shares. At the start of the day, the stock is worth (ie was last traded at) $7. All 10 investors actively try to determine what the stock is "really worth" (whatever that means) Imagine half of the investors decide it's worth 8 dollars and the other half decides it's worth $9. The guys who think it's worth 9 will bid up the price until it's high enough (say, $8.05) to compel the other half to sell to them.

The big point here is that price movements occur from divergence of opinion - the reason the stock moved from $7 to $8.05 is that some guys thought it was not worth more than 8 while other were ready to pay 9.

What happens if there's no difference of opinion? If the stock is at $7 and all 10 investors decide it's "really worth" (whatever that means!) $4 - no trading will occur! They would each be happy to sell it for any amount above $4, but  none of them are going to buy it for more than $4! In fact, the only way that any trading will occur in this situation is if at least one of the investors needs to sell stock to get cash - in that case he'll have to sell for under $4 to induce any of the other 9 to buy. Alternatively, if one of the investors was somehow compelled (more on that later) to buy this stock - they'd end up paying a over $4 to get it - even though it's more than it's worth...

So the big idea here is that in the absence of divergent opinion, supply and demand for cash redemption/investment drives the price.

How could things go wrong? Imagine 9 guys know that the 10th will sell his shares because he needs cash. If they all think the stock is worth $4 - are they going to be good citizens and buy the shares form him at $3.99? My bet is they are going to refuse to trade at that price and only buy from him at like $0.01 - the information that he must sell is powerful. Similarly if they all knew that one guy needed to buy, they'd force him to buy it well above the "real worth" of $4.

Luckily, the stock market is composed of thousands of stocks and millions of investors, so no one can predict that there will be an absolute supply or demand for a stock that they can take advantage of.

How Passive Investment Works - Two Paragraph Version!
So remember that first example where some guys decided the stock was worth $8 and others decided it's worth $9? One half of them was wrong - if the stock ends up at $15 in a year, the buyers are happy and the sellers are kicking themselves. If the stock ends up at $2, the sellers are happy with their decision and the buyers are ruined. Since the stock market is unpredictable and random (that's a different topic altogether but I feel confident in this statement for what its worth) - a trader has a 50/50 shot of being "right" or "wrong" on any given trade.

But! The process of determining what the stock is worth is costly and time consuming! Think of all that research, time spent reading statements, investor calls, and following the CEO on Twitter. If the cost of research averages out to $1 per share, when you buy a stock at $10 and it goes to $15, you only make $4 (but you consider that $1 well spent) but when you buy at $10 and it goes to $5, you lost $6!

So what happens is... one of the investors decide they are sick of paying $1 just to be "wrong" 50% of the time. So instead, they don't bother figuring out what the stock is worth, they just trade at whatever price is there based on the research of the other 9 investors. So they are still wrong 50% of the time, but they make $5 (not $4) when their stock goes from $10 to $15, and they lose $5 (not $6!) when it goes from $10 to 5. That's passive investment in a nutshell!

How It All Goes Badly
The passive investor guy is kind of like a little car drafting behind a large truck. The truck isn't really affected, and the car's driver pays a lot less for the gas. The only problem is, he has to follow the truck to its destination rather than figuring out where he wants to be, but he's fine with that since he knows he'd on average make the same choices as the truck.

But in this case, passive investment has significant impact on the active. For one, it attracts a lot more funds, since individuals see that they can get the same returns as the active guys at a lower cost. This deprives the active guys of "assent under management" (AUM) - on which they charge fees that pay for all the hard research they do. It also puts pressure on them to lower their fees - a double whammy.

So over time, more and more of the 10 investors in our scenario become passive. What happens when most of them are?

Well, for one, the "quality" of prices goes down a lot. Whereas in the beginning, we had 10 people doing their best to figure out the "correct" price of the stock, we may be in a situation where 1 or 2 guys are trying to do that - with fewer resources due to shrinking AUM and fees, while the other 8 are blindly accepting whatever price is out there. No matter how you slice it - 10 people doing their best research were more likely, in aggregate, to come up with the right price compared to 2 resource strapped people...

What's more, the price becomes a lot more driven by cash flows than fundamentals. If the two guys are doing active research and decide the stock is terrible, but the other 8 have incoming cash that they must invest in this stock because its part of the index and there was an inflow of say retirement investments, guess what - there's more buying than selling! So even though fundamental research says the stock should go down, the stock goes up driven by blind demand.

This has a side effect of completely killing research-driven investing. What's the point of doing research to determine which stocks are good or bad, when their prices will be driven by the blind demand (or supply) based on cash flows of the passive investors? Even if I am right in what the price "should" be there's no market mechanism in this scenario that will make the it get there.

Remember - it's the difference of opinion that drives stock prices in a correctly functioning market. If there's no difference because there are no opinions, prices are going to be driven by the need to buy and sell.

So here's where it gets really rough. Remember the example where 9 traders knew that 1 had to buy (or sell) and they gouged him? The same happens here. If I own a stock that's a part of an index, and I know that people are overall saving money and investing it in passive managers (which I can know easily) - they why the heck would I sell my stock to the passive managers today when I know they will need it and continue needing it more and more each time they get cash to invest? I will hold to this stock or only sell it at a completely ridiculous price - which I can do since I know my counterpart must trade.

Trading depends on there being a buyer and a seller - if everyone follows the same index passively, and a stock is part of the index, everyone will want to buy that stock at the same time (assuming there are general inflows into the market) or everyone will want to sell it at the same time (if there are systemic outflows.) So this means that stock prices will rise very rapidly during inflow times, and drop precariously when there are outflows.

For an investor in a passive fund that means buying when everyone's buying (ie, high) and selling when everyone's selling (ie, low) which is not how you make money generally.

Finally, there's the cataclysm scenario - without active investors, there's essentially no oversight for companies and no regulation of their prices by intelligent market forces. Rather, the stock will go up while it's in an index, and the only way it'll be removed from it is not gradually as it declines with increasing investor concern, but suddenly as the company goes bankrupt in a surprise to all.

What's to be Done - Bad Ideas
There are a couple of ideas that could mitigate these issues, but I think they are bad and won't work - but they might get tried.

First, companies or markets may chose to forbid passive investment in themselves somehow. This is unlikely since nobody wants less trading or more supervision.

Second, some means may emerge to counterbalance the supply and demand trends from the passives - for example to make long term bets against the index.

Indexes themselves may change how they are composed to somehow mitigate liquidity constraints. EG an index could "self re-balance" to avoid soaking up the entire stock of any given company.

What's Actually Going to Happen
So the thing to remember is that passive investment isn't some amazing thing - its successful against active managers because it's "just as wrong on average but a lot cheaper." An active investor is human - emotional, greedy, scared, biased - and he wants to get paid for his work. The indexer "wins" not by being smarter but by not thinking (and thus, allowing his emotions to bias him) at all, and paying less in the process.

For example, imagine that the active manager was information driven but cheap and free of human biases - like an algorithm that did analysis of a stock and valued in on just two factors: predicted dividend flow over the long term, and impact of passive investing flows on the price of the stock based on knowledge of the index and the overall pattern of cash flows in and out of the market. This should win over the passive guys in average - it uses 2 decent data points: one pertaining to actual income from the company and one pertaining to predictable market forces - while passive uses no data points. And the cost at the end of the day should be roughly similar.

Over time, such investors ought to draw funds away from purely passive - they ought to offer better performance at similar cost, by choosing companies based on fundamentals.

So, back to fundamentals?
At the end of the day, a company should be worth the present value of all its dividend flow. While everyone's more interested in how much they can sell the stock to someone else for, at the end of the chain somewhere someone must be getting revenue from the business, not the "greater fool" to whom they can sell their shares. As investors, we don't think about dividends much because we think about capital gains and the stock price is driven today by tons of factors not related to fundamentals - the fact that a brainless passive strategy is something we even consider talks about how crazy we've gotten with valuations and trading. The passive investment trend should smooth things out while increased technology and data transparency can allow us to actually make better investment decisions at a low cost as a matter of fact.

Saturday, December 6, 2014

The Million Future Nows

This morning, I read Linda Tirado's "Why Poor People Stay Poor" in Slate. She argues that "saving money costs money" (this is the actual subtitle of the article) and the poor don't have the luxury of making good decisions because virtually all their spending happens as an emergency. Essentially, the poor are too poor to shop for good deals.

Tirado is right about the mechanics of poverty, but she treats it as a given, as an exogenous phenomenon that happens to us, over which we have no control. She's wrong.

Tirado's knows she can't get ahead of expenses because there's no emergency buffer, no runway. But she dismisses building the runway. She acknowledges that her day-to-day decisions keep her poor, but she doesn't do anything differently. Saving, she says, is for the rich.
"When I have a few extra dollars to spend, I can’t afford to think about next month—my present day situation is generally too tight to allow me that luxury. I’ve got kids who are interested in their quality of life right now, not 10 years from now."
That's the trap. She has it exactly backwards: she can't afford not to think about next month, because next month won't be any better unless she does. Yes, we care about quality of life now, but now is almost over. Next month and the month after that, we will care about our life in a different now. But unless we do something today that will make the future nows better, they will suck just as much. Tirado choses to make the current now a little better at the expense of the future. These decisions add up:
"If the good toaster is 30 bucks right now, and the crappiest toaster of them all is 10, it doesn’t matter how many times I have to replace it. Ten bucks it is, because I don’t have any extra tens."
She's wrong, because it does matter how many times she'll have to replace the toaster. It matters a lot! She denies having agency and digs herself deeper. Must she buy the toaster right now? Is it possible to toast bread on a pan rather than spending your last tenner on crap? Can this purchase wait until a more favorable time? She says no. She understands her total toaster expenditure will be greater but doesn't make a different choice. Why?

There's a tendency to view our current lifestyle as the absolute bare minimum, that we can't possibly live on any less than what we make now. This is independent of level of income. A young professional who "can afford" to go out to dinner and drinks every night but has no savings is no less vulnerable than Tirado. And it may seem as impossible for them to not go out as it is for Tirado to live without a toaster. Without a runway, changes in our incomes are catastrophic. We may have higher quality of life than Tirano, but unless our answer to "how long can you live your lifestyle if you lost your job" isn't "pretty damn long," we are vulnerable.
"It is impossible to be good with money when you don’t have any. Full stop. If I’m saving my spare five bucks a week, in the best-case scenario I will have saved $260 a year. ... If you deny yourself even small luxuries, that’s the fortune you’ll amass."
This is Tirado being an idiot. "$260 is so small, I can't care about saving it." She complains of lacking any financial flexibility, but here she is, pissing away a chance at it. Can we assume $260 would actually make a big difference to her right now? Didn't she know she'd need it when she chose not to save it? It's possible the memory of those past "small luxuries" makes her happier than a bit of financial flexibility would, but I doubt it.
"Of course you will never manage to actually save it; you’ll get sick at least one day and miss work and dip into it for rent. Gas will spike and you’ll need it to get to work. You’ll get a tear in your work pants that you can’t patch."
This is a fatal flaw in Tirado's relationship with money. This is how she keeps herself in the cycle. This is her locking herself into poverty. Anticipated emergencies somehow translate into "why bother saving " rather than "save now so I can buy pants on sale, not when I tear my only pair." She is literally saying  that she'd like her next expense to be another emergency.

Tirado makes choices that ensure she doesn't have a runway, then attributes later bad choices to not having a runway. She understands how it works but is unwilling to take action that can make things better.

It sucks to be poor, and it sucks to be vulnerable. I've been there and I have sympathy for Tirado, her family's life sounds legitimately hard. But she's not making it easier when her in-the-moment choices shortchange the future. $260 a year is not a lot, but it's 8.6 quality toasters.

Tirado talks about money-saving strategies (buying in bulk, proper vehicle maintenance) as luxuries of the rich. But if she were just $260 wealthier, would she not be able to buy air filters for her car and a bunch of cereal for her kids? Would that not get her on the right track, where she's buying a $30 toaster once and not a $10 one over and over?

Being too poor to save money is like being too fat to exercise or too busy to learn time management. Tirado is right, it's easier to continue doing well once you're already doing well. But that's an argument for doing whatever it takes to get on the right track now, not against it. The work and pain of now will soon be in the past anyway, but they determine how much you enjoy (or hate) your future nows.

Tirado connects causes and effects, except those of actions over which she has direct control. She isn't willing to make the "now" suck a little more even if that means improving a million future nows for her and her family. And this isn't just her, and it's not just low-income folks. When we borrow for a vacation, or smoke a pack of cigarettes, or simply lay around in front of the TV, we are in some way borrowing from our future selves. This is human nature. And we have to draw the line somewhere, at some point we have to let ourselves relax and enjoy rather than building maximally optimal futures for ourselves. But it doesn't sound like Tirado is at that point, and it doesn't sound like she gets enough joy out of her small luxuries and crappy toasters to justify keeping herself on perpetual brink.

Sunday, December 1, 2013

Why I don't trade stocks and (probably) neither should you.

This post is a more thought out version of my response to friends asking what stocks they should buy. The short answer is: none. Unless you have a sophisticated investment strategy (in which case you aren't turning to me for advice) you should invest the bulk of your funds in low-cost index funds.

This statement is neither profound nor new, yet lots of smart people I know trade at least occasionally. To begin, let's define the criteria under which this behavior is sensible:

Stock picking only makes sense if we expect to consistently outperform the market averages (approximated by broad index funds). Not only do we have to beat the average, we must do it by a wide enough margin to cover higher trading costs along with the opportunity cost of our time. In other words, the answer to "do we believe that our stock selection ability is significantly above average?" has to be a resounding, objectively justified "yes." 

This is where most of us should stop, because we have no reason to make this claim. This is where I personally stop. Despite a decade of working in capital markets, holding the CFA designation and being half-way through the MBA program at Stern, I know that, short of insider information, I have no reason to expect to outperform the market. Chances are, nether do you. 

But chances also are you aren't exactly convinced, so let's dive in.

"It's going to go up!" (unless it doesn't)
We buy an asset because we expect its price to increase. We might decide this based on gut instinct or research. We might evaluate the company's products and management and claim its prospects to be good. One way or another, we decide the stock must rise.

Imagine Yves buys the stock today. His purchase raises the price up a bit (supply and demand) so the next buyer will pay a bit more. The buyer after that trades a bit higher still, etc. Eventually, the price rises higher than is "reasonable" even given the company's rosy prospects. Cecil, who buys at this price, should expect to lose money.

The problem: how do we tell if we are Yves or Cecil?  There's no way. In fact, current prices reflect consensus, so the very act of buying is more aggressive than average and therefore likely to be a mistake. Unless we see something no one else does (and have good reason to believe that no one else sees it), there's no reason to expect any asset to go up. It's already "up." And unfortunately, unless we are  trading on insider information, everyone has already seen what we see.

So again, we should really stop here because there's no reason to expect a stock to rise. But you probably still aren't convinced. So let's look at 3 common justifications for trading.

"The stock is cheap now because everyone's over-reacting" (unless they aren't)
A common one is "buying the dip." Negative news comes out and the stock price tumbles. We decide that everyone's overly freaked out and the company's prospects are really not impacted. So we buy and wait for the stock to recover.

Unfortunately, even if we are right, there's no mechanism for forcing the price back to its previous level. Or maybe it was overpriced and the bad news sent it back to a realistic valuation. Or maybe its still overpriced. Or perhaps the news is that bad. We just can't tell.

Here's the price chart for Citi Group from 2007 to today. Lots of dips. Trading them would have been disastrous - though lots of people did just that. Any of those dips looked, at the time, like the bottom. Only the ones in early 2009 and 2011 were, but alas we can only recognize that in hindsight.

Did anything really change at Citi since 2007? It's in the same lines of business, going after the same set of customers. If anything, it's probably leaner and more efficient than it was back then. You can say the business environment changed, but we could have anticipated that. Citi faces the same prospects at $52 as it did at $520. And at 97 cents. If the same basic company can trade at exponentially different prices, does it make sense to bank on dip correction?

IPOs always go up (except when they don't)
If we can't rely on dips, can we trust the conventional wisdom that getting in on an IPO is a sure way to make money? Sometimes that's true, sometimes not. Many stocks go up on IPO and then crash. Many stocks don't go up on IPO but rise later. Which way the will next IPO go? 

We don't know, but we can guess based on how and why IPOs happen. Originally IPOs were meant to raise capital, but Google, LinkedIn, Facebook, etc. didn't IPO out of desperation for money. They sold shares as a way for founders and early investors to cash out. Put yourself in the shoes of a pre-IPO investor going through a "pop": your stock IPOs at $10, and closes at $20. That's great for everyone who's not you, since you sold your shares for half of what someone was willing to pay. You'd never intentionally let that happen. IPOs are priced by people with the most insider information and an interest in getting a high IPO price at the start. So why would we expect a "pop?"

It's a good company (yeah, but might be a crappy stock)
If we cannot speculate on IPOs, why not invest in stable companies? A popular version of this is the practical grandma who invested only in firms whose products she used. We like a company. We love its products. We see no way for it to go down in flames and we expect others feel the same way (ie no chance of a panicked sell-off.) Why wouldn't we buy this stock?

It goes back to pricing. Everyone else likes the company too. Chances are its stock is already bid up high. Also, our imagination for seeing a company crash and burn (or die a slow death) is, empirically, pretty bad. GM was a stable company that sold lots of products. Then one day, the same GM was viewed as saddled with labor costs and unable to design a reliable or efficient car. So we aren't safe investing in "good" companies. And if we were safe, there'd be no money in it.

Bottom Line
There are many versions of the story investors tell to justify their trades: the stock must go up because the company is good, or the news is overblown, or it's an IPO guaranteed to pop. Unfortunately, it's not enough for us to be right (even if we are). Everyone else needs to be wrong in order for us to profit.

So I am leaving you with this: every time we trade, someone trades the other side. Are we smarter than them? What if they are right and we are wrong? Personally, I like to visualize my counterparty as Goldman Sachs. If Goldman's as eager to sell a stock as I am to buy it, shouldn't I just not trade?

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