A big spaghetti bowl of finance concepts
You’ll love it.
Some concepts don’t fit neatly into other posts. They’re really important, but they don’t have their own natural place yet. So I planted them here. Please enjoy.
Financial markets are prediction machines, not mirrors of current events
If Mark Zuckerberg announced that in six months, he will direct his company to buy a billion dollars of collectible beanie babies as an investment, the company’s stock would likely fall. Notice that the reaction would not wait for the purchase to occur six months later; the stock price would fall in anticipation of the poor business decision. That’s what it means for an event to be “priced in”. As the event unfolds, details that were not fully anticipated might cause further price movement.
The value of a bond can be affected by events until maturity, which could be two or 20 years in the future depending on the bond. Because stocks are perpetual securities — they can last as long as the company does — share prices can account for anticipated events with no end date.
What is a company worth if it loses money? From a narrow perspective, companies that are burning through cash and have never turned a profit should have a share price of zero. But investors value the profits they expect a company to generate years and decades in the future, not the current state of the company. These companies tend to have fickle stock prices, because a single piece of news can drastically shift expectations about the nature of future profits. Early-stage biotech companies can have essentially binary outcomes, if their future depends on successful trials and FDA approval of a single drug.
A forward-looking perspective means that even bad news can generate positive stock returns, if the news was not as bad as expected. Consider this Wall Street Journal headline from 2024:
Tesla shares rose on the bad news, because investors were expecting even worse news. Lower vehicle deliveries were already priced in, to some extent. The same lesson applies to economic recessions: when the stock market begins recovering amid a poor economy, that doesn’t mean investors have an upbeat attitude. It means that expectations for the future are being revised in a positive direction. During the last two deep economic recessions, the US stock market bottomed out in March 2009 and March 2020. Bad news and uncertainty persisted long after the lowest points but, in retrospect — and only in retrospect — we can observe that those moments encompassed the worst outlooks for future economic conditions. The upward trends following each bottom reflected a tentatively improving attitude.
Liquidity
A highly liquid asset is one that you can sell quickly with minimal cost and minimal effect on the market price. You could sell a million dollars of Apple stock in seconds or minutes, and you wouldn’t even be a footnote in its daily trading volume. Assets with lower liquidity include jewelry, art, real estate, precious metals, and private businesses. Hurrying to sell them, or selling in large volume, can significantly lower the price at which you’re able to sell. Liquidity is defined by the ease of converting an asset to cash, but the dynamics of liquidity apply to buying as well as selling.
Buying stocks or other assets in large amounts tends to move the price upward, and selling tends to move the price downward. This is a trading cost that barely exists for most individuals, but funds that grow to enormous size can be hindered by this cost. It’s one of the reasons for diminishing returns with scale that we discussed in the intro to investing.
Liquidity is always relative to volume. A hamster could buy a million dollars of Apple stock with no issues, but buying $36 billion of it (as Berkshire Hathaway did) requires patience and strategy. Buying too much at once would exhaust the pool of shareholders willing to sell at the current price, driving up the buyer’s average price. Compare this with real estate: you might be able to sell your own house quickly if the market is normal, but if a lot of properties in your area are competing to sell, you may need to wait or drop your price significantly. Regardless of urgency, transacting real estate carries high costs in the form of fees, commissions, and taxes. Apple stock, on the other hand, has a very small bid-ask spread (which is the main trading cost if moving the price is not an issue).
Liquidity can be impaired by rules governing tax-advantaged accounts. If you withdraw money prematurely from a traditional retirement account, you may have to pay income tax plus a 10% tax penalty on the amount you withdrew. Even though the assets in your retirement account can be converted to cash easily, the act of withdrawing that cash is costly. So assets in tax-advantaged accounts can be less liquid.
A person or company could be described as liquid or illiquid based on their asset mix. A “house-poor” person who spent all their money buying a home is illiquid because the bulk of their net worth can’t be easily liquidated — converted to cash.
Expected return
The expected return of an investment isn’t really the return you expect. When buying a volatile investment like a stock fund, you should expect a wide distribution of outcomes. The expected return is just the mean (average) of that distribution.
We can make it tangible: roll a six-sided die. The possible outcomes are {1,2,3,4,5,6}, all of which are equally likely. The mean of those six numbers is 3.5, which is the expected value of rolling the die, even though it’s not a possible value! It’s just a calculation.
When we ask a question like “What’s the expected return of the global stock market over the next year?” it becomes far more subjective than rolling a die. We can use the average historical return, but we could also try to adjust the prediction with other factors. It’s even more difficult to settle on the expected return of a subset of stocks: “emerging markets” or “Japanese small caps”.
In any given year, we should expect a stock return that falls far from the expected return, because the distribution of stock returns is so wide. Stocks have an expected return around 8%, but we don’t anticipate a return close to 8% very often.
In the gentle intro to investing, we saw this visual comparing the distribution of returns from US cap-weighted stocks and US aggregate bonds. Each purple diamond is the average return over 1995-2022. This is just one 28-year period, but you can see that the annual returns of bonds cluster more tightly around the average return.
This video on stock returns by Ben Felix is a great explanation:
What we might want to refer to as an extreme return — that is, below -8% and above 15% — should be considered very normal. … Normal returns are random and extreme.
Security
Even if your only financial experience is watching The Wolf of Wall Street, you’ve probably heard of the SEC: the US Securities and Exchange Commission. Any public stock or bond is a security: an interchangeable financial asset or instrument. That’s a broad definition, yes, for a broad term.
Every share of AMZN is interchangeable, but two luxury watches — even of the same make and model — are not. A share of a fund like VT is also a security. There are other types of securities, like options and futures, that the average investor does not (and probably should not) ever trade.
The Howey test is an important legal definition of a security from a 1946 Supreme Court decision. It states that an investment can be regulated as a security if there is an investment of money into a common enterprise, with an expectation of profit from the efforts of third parties. Since around 2017, the Howey test has been pushed into more mainstream conversations by the question of whether cryptocurrencies should be regulated as securities.
Securitization is the process of packaging assets that aren’t easily tradable into tradable securities. Mortgage-backed securities are a multi-trillion dollar example: large numbers of mortgage loans are bundled into a tradable security, allowing anyone to invest in a diversified portfolio of mortgages. Banks can make money by originating and servicing mortgage loans, while offloading the risk to other willing investors. You can buy mortgage-backed bonds through a fund like MBB or VMBS (but again, I wouldn’t suggest it to the average investor).
Is my money safe?
Many people are aware that bank accounts in the US are insured by the FDIC up to $250,000 per depositor, per bank, for each account type. Client assets at US brokerage firms are also insured, but there are many regulations intended to protect client assets before insurance is ever needed. As FINRA stated here:
In virtually all cases, when a brokerage firm ceases to operate, customer assets are safe and typically are transferred in an orderly fashion to another registered brokerage firm. Multiple layers of protection safeguard investor assets. For example, registered brokerage firms must keep their customers’ securities and cash segregated from their own so that, even if a firm fails, its customers’ assets will be safe. Brokerage firms are also required to meet minimum net capital requirements to reduce the likelihood of insolvency, and to be members of the Securities Investor Protection Corp (SIPC), which protects customer securities accounts up to $500,000. SIPC protection comes into play in those rare cases of firm failure where customer assets are missing because of theft or fraud.
Notice that securities in each account are insured up to $500K. So a client’s taxable account, Roth IRA, and traditional IRA at the same firm are each covered up to $500K. In addition, mainstream brokers purchase private insurance for potential losses far beyond those covered by the SIPC.
Brokerage firms are not subject to the same “bank run” vulnerabilities as banks and credit unions, because brokers have no claim on your securities. A bank as large as JPMorgan Chase could reach its breaking point if too many clients pulled out their money at once. On the other hand, a brokerage like Fidelity could find any number of its clients transferring their accounts, and it would have the securities ready to go.
What if your brokerage is okay, but an asset manager becomes insolvent while managing your money in a fund? If an asset manager like BlackRock were to fail, and you were invested in one of their funds, the company wouldn’t have a claim on your securities. The fund would be transferred to another manager, or the assets would be liquidated and returned to shareholders. Even your life insurance policy can be purchased by another company if your insurance company kicks the bucket (and there’s a limited backstop for insolvent insurance companies similar to SIPC).
Your money is safe — it’s yours to lose!
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That’s all for today, I hope you learned something! See you next week.
Further resources
Every Money IRL post is organized in The Omni-Post, and all vocab terms are here.
Benjamin has a funny YouTube channel about investing badly, which is why I linked this video above.
Check out the video on expected stock returns by Ben Felix (no relation to Benjamin).
If you aren’t familiar with some of the terms used above, like “bid-ask spread” or “small caps”, please check out the gentle intro to investing.
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Oh Sam Sam ♥️
Great post!