101: Q&A Ep1. (Losing Your Stock Market Virginity)

101: Q&A Ep1. (Losing Your Stock Market Virginity)

You’ve got the questions, we’ve got the answers.

(Q1.) Should I invest in pension plans? Are they the same as mutual funds?

A pension plan is a very good idea and it’s very similar to a mutual fund. When you go to a pension plan provider, you’re basically putting in an amount of money every year and that is being invested in a number of mutual funds.

The bonus to investing in a pension plan in Malta is that the government gives you a 25% tax rebate on up to 3k worth of deposits. That’s like starting off with, on average, 3 or 4 years’ worth of returns, risk free.

(Q2.) Is the concept that the economy will always grow realistic?

To start off with some basics, economy size is measured in GDP, which is essentially the total value of goods we produce in a country in a given year. This figure is also the total value of income taken home by people. This is why the government is always trying to increase the GDP per capita, as it means more money to spend and hence a better quality of life.

GDP growth, consequently, means that revenues for companies in that economy will grow and with long run GDP growth you should also expect the price of your stocks to increase as companies will be making more money. Therefore, if long run growth had to stop or decline, could we see stocks only decline from here on?

If GDP had to stop growing, potentially yes, but this is really unlikely. Long term sustainable GDP growth is possible and very probable. Here’s why.

GDP can grow for different reasons. One can be due to population growth. If the population grows by 10%, then 10% more goods are required to fulfil their needs so GDP will likely be 10% higher due to population effects alone as companies produce more goods to meet demand. However, this factor is not something to rely on since a declining birth rate and ageing population are leading to predictions that the world population will peak and dip. Finding more natural resources is also unlikely to lead to much more GDP since the world is quite well explored in that regard.

The factor that can significantly and sustainably increase GDP is productivity, which can be obtained through more education (the world is continuously becoming more educated so people are able to produce more), investment in infrastructure (for example, building roads enables delivery companies to do more deliveries per hour), and improvements in technology. 
To give you an example of how technology can increase GDP, think about the space tourism industry. At the moment, it is only available to a select few rich people. Once the technology improves to a point where it becomes affordable for the every day person, suddenly many more people will go and that all adds to the GDP. Airlines took the same route in history. At the beginning, they were for the wealthy few. Nowadays we see everyone taking trips. Another might be vertical farming. Vertical farming in towers allows you to produce vastly more vegetables in the same amount of square meters. Therefore, the only way I see us not continuing to improve GDP in the long term is if we stop innovating and re-investing, which is unlikely.

Above is a graph of the S&P 500 for the past 145 years, tracking the biggest stocks in the US. It has moved in the same direction as GDP through these years. GDP growing means revenues for companies grow, which means stocks grow. Further growth in GDP will keep this index going upwards. There are some blips along the way but as long as you buy and hold for the very long term, you make money.

(Q3.) You mentioned how passive investments are desirable for people who have less time to actively manage their investments, but even if you had the time would you not have statistically better odds following a team of experienced professionals (like ARK etc) than throwing some Hail-Mary’s as a twenty-something year old?

Throwing some Hail Mary’s on individual stocks is definitely a risk. Following an ETF that tracks an index isn’t, it’s a well-diversified portfolio of good companies. Look at the S&P long term chart in this article, you’ve just got to be able to stomach the periodic drops because in the long run the economy is growing. Being a passive investor and simply investing in an index-tracking ETF is already pretty good.

Now if you want to be a bit more active and choose a management team that has either a mutual fund or an actively managed ETF, which both try and beat the market index, that’s a valid alternative. The issue is that they don’t beat the market on average according to research. The out performers in any given period tends to be by chance, and longer term performance of funds tends to go towards the average again. 
Let’s take your example of ARK ETF. Indeed, they have done well over the last number of years. But then you look at their portfolio and all the companies in there trade at very high valuations. So it could be that they have benefitted from the valuations going to very high levels recently but if those valuations start to normalise, as is the case throughout history, then they could have years of underperformance to make up for their previous outperformance. Although this is likely the case, there is of course the chance that they are one of the rare teams of prodigies. They’re smart, but then again remember that the people at all investment companies are just as smart.

This doesn’t mean that there aren’t teams that can outperform long term. Funds don’t outperform the index on average, but there is research that shows how to distinguish between funds that have a much better probability of beating the market. If the fund/ETF is small in terms of assets under management, if the quantity of stocks in the portfolio is rather small (maybe up to 50 stocks), and if their strategy is buy and hold for the very long term with little change in stocks within the portfolio, then they generally have a much better chance. Personally, what I like most about funds/Active ETFs is that you have the peace of mind of someone continuously looking at your portfolio and doing all the work for you, rather than any special performance.

(Q4.) Why not just buy a stock impacted by COVID and wait till lockdowns are inevitably over?

When you’re buying a stock, you’re buying a piece of a company. The stock price today incorporates all future earnings expectations. Basically, the value of a company right now
is summarised as the value today of all the cashflow it is predicted to generate in the future. So, if this year’s earnings are expected to be 60M due to COVID and all subsequent years have a recovery where earnings are 100M, this is incorporated into the price right now. If we get to the second year, and the earnings are indeed announced higher at 100M, the stock will not change in price. That increase was already incorporated into the stock price. In the stock market, focus on the difference between expectations and reality. If the company had announced that the second year earnings were actually 110M, higher than expectations, then indeed it will rise. The stock price today only incorporated 100M worth of earnings not 110M, so it has to adjust.

(Q5.) How do brokers with 0 commission make money?

When you get trades for free from some brokers, you may start to question how they’re screwing you over. They need to stay in business somehow. Instead of generating revenue through commissions, they generate revenue through other methods. 
One of them is the bid-ask spread. If you look up a share price on Google Finance, it might say the share price is $16. However, if you were to buy it, they may charge you $16.01 and if you were to sell it, they would give you $15.99. In effect, it’s a very small inbuilt commission. 
Another way is, since you have some cash in your account not invested, they gather that cash from all the users and invest it or lend it out. 
Lastly, they can make money from order flow. This is basically when a large financial company pays the brokers to be on the other end of the trades of all its users. So, for example, if you buy 10 shares of Apple, one of the companies that gets to sell you the 10 shares will be one of the big financial companies that pays the broker for the right to trade with you.

(Q6.) What do you think on the research recommended by brokers?

Smart people work at brokerages so they know their stuff. However, it is not wise to invest based solely on what a broker tells you and recommends in their research, you need to learn to do your own research. The reason is that a broker has a conflict of interest, they need to make money from you at the end of the day. They make a commission every time you buy or sell a stock. Therefore it makes sense for them to tell you to buy this or sell that because they’re going to make a commission once you act on their recommendation. The best way to approach brokerages is to focus on their primary purpose: to enable you to make the purchase of the investments you want at the cheapest possible commission.

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