When you start investing in stocks, you’ll probably learn a lot the hard way. You’ll make money. You’ll lose money. And some things you’ll only learn from being in the ‘know’. Here are 5 stock market secrets a financial advisor won’t tell you.
1. What happens after a stock trade is executed?
So, you’ve put a buy order into the market and it’s been executed. What happens now? On the procedural route, this is an easy question to answer:
- Money is taken out of your broker cash account to pay for the shares
- The broker will take a commission, or ‘execution fee’
- The stock is added to your shares account
If you’re selling shares, your account will be credited with the sale proceeds when settlement occurs. This is dependent upon the market in which you’re selling. In the UK and most of Europe, the standard settlement period is two business days.
Most brokers’ trading systems will allow you to reinvest the proceeds of a sale when it is made. So, you may not have to wait until the trade has settled to buy the shares of another company.
A more interesting question is, what do you do after a trade is executed?
Most self-directed investors, especially when starting out, suffer a wave of doubt:
- Have I paid too much for the shares?
- If someone wants to sell, should I be buying?
- What if the market crashes?
You will probably be a little nervous. This is not a bad thing. It’s called ‘rational fear’. It’s real money. Your money. This rational fear helps ensure that you’ve done your homework. If the stock price falls a few pence in the next few minutes, does it matter? You’ve bought the stock because you’ve done your research. You’re confident that the company has a bright future. Relax. Put the kettle on, and put your feet up.
Protect your sanity… and your profits
Whenever you invest, you want to protect your profits. Because markets can turn on a sixpence. No matter what the fundamentals say, market sentiment plays games with the stock market. If sentiment turns sour, the market fall can be a bitter pill to swallow.
Therefore, It’s a good idea to accompany your stock purchases with a stop-loss order.
How does a stop-loss order limit your losses?
A stop-loss order executes when the share price falls to a level that you set. Let’s say you’re prepared to lose a maximum of 5% on an investment. If the stock price is 100p when you buy, you would enter a stop-loss order at 95p. If the stock falls to 95p, your sell order is executed.
How can a stop-loss order maximise your profits?
You can use a different type of stop-loss order to protect your profits. Called a trailing stop, the limit moves higher as the stock price moves higher.
Let’s say you buy a stock at £10. It advances to £12. You don’t want to sell, because you still believe the stock could go higher. You place a trailing stop at 5%. This means you will sell your shares if the price falls 5% from its highest price. The shares go to £14. Your stop-loss is now at £13.30 (5% below £14). If the shares then rise to £15, the stop-loss limit rises to £14.25. If the shares fall to £14.25, your shares will be sold. Your profit is protected from further erosion because of a falling share price.
Stop-losses give you peace of mind
For the self-directed investor, stop-loss orders are invaluable:
- They offer peace of mind
- You don’t need to watch your holding 24/7
- If a stop-loss executes, you’ll have the breathing space to review your investment
You may decide to buy the shares back, or perhaps to move on to a new investment opportunity.
Stop-losses eliminate bad emotional investment decisions after a trade has executed. When you eliminate emotions, you stay in control of your investment. You’ll make better investment decisions. And you’ll invest more profitably.
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2. High-frequency stock trading – an evil that benefits direct investors?
You may have heard of high-frequency trading, or HFT. Michael Lewis’s book, Flash Boys. If the term is alien to you, let me introduce you.
What is high-frequency stock trading?
HFT is, effectively, automated trading by robots. Computers are programmed to analyse stock and futures prices, and then trade on discrepancies. These discrepancies might last for only a few milliseconds. To the naked eye, they don’t even exist. Blink, and you’d miss them. HFT traders rely on trading at the speed of light (almost) to take advantage of these discrepancies.
The S&P futures should always be perfectly correlated to the underlying index. HFT traders take advantage of those milliseconds when they’re not. The margins are tiny, and so HFT traders rely on being able to trade hundreds or even thousands of times a day.
How high-frequency stock trading helps ordinary investors
HFT has produced some distinct advantages for ordinary investors.
For example, added liquidity. HFT traders need to trade large volumes to make real money. That kind of liquidity is good for ordinary investors. It makes buying and selling easier. With this increased liquidity comes an even bigger benefit.
HFT has crushed stock spreads. Twenty years ago, the average spread was almost 1%. When you bought a stock, it had to rise by more than 1% for you to break even. Today, the average spread is around three basis points. The smallest move up could put you into profit.
How high-frequency stock trading hinders ordinary investors
In Flash Boys, Michael Lewis describes how HFT firms started to harm the business of mutual fund managers. The mutual fund would place an order to buy stock on one exchange. The order would be filled. By the time the fund manager went to other exchanges to complete its order, the price had moved higher.
HFT firms had ‘seen’ the first order, and stepped in front of the mutual fund on other exchanges. Therefore, the fund manager ends up paying a higher price. The result is that the underlying investor – the ordinary investor -pays a higher price. And when selling, the sale price is a little worse than anticipated.
Is HFT new?
HFT isn’t new, it’s just taken a different, technological form. Traders have been trying to be the first to market for as long as markets have existed. Years ago, hand signals were invented to convey orders quickly across crowded rooms. These have eventually been replaced by computers. They are programmed with algorithms, and trade automatically over high-speed fibre optic cables.
Should you worry about HFT?
The short answer is no. Unless trading in hundreds of thousands of shares, you’ll reap the benefits without suffering on price. HFT is not going to go away. Some market authorities are trying to curb it. But any new rules they bring in will simply make HFT firms find a new way to trade. In the meantime, thank HFT for narrower spreads and great liquidity. That makes it easier to trade, and easier to profit.
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3. Investors overpay for fund management almost every time
Let me ask you this question: would you sell your house through an estate agent who charged you even if the house didn’t sell? Your house is worth £200,000, and the estate agent charges you a fee of 2.5% to manage the sale for you. If the price fell to £150,000, you still pay the estate agent £5,000. If the price they get is £220,000, you pay £5,500. Doesn’t seem fair, does it? The pricing is completely biased towards the estate agent. That’s how fund managers work. But it gets worse.
Win, lose or draw, the fund manager is never out of pocket
Whether your fund value rises or falls, the fund manager takes its pound of flesh. According to Which? magazine, average annual fees on a UK managed fund are:
- Annual management charge of 0.75%
- Additional costs of 0.1%
- Turnover costs of up to 1.8%
That means you could be paying charges of more than 2.5%. And if you take advice before investing, your investment advisor will take a fee, too.
But at least you get professional management and better performance, right? Wrong!
Most managed funds underperform
A study by S&P Dow Jones in 2016 found that almost all actively managed funds underperform the market. You’d be better off buying a cheap-to-own ETF on the S&P 500. The study found that:
- 86% of funds sold in Europe underperformed their benchmark over the last ten years
- 99% of actively managed US funds underperform
- All fund categories in the UK underperformed over ten years
How can you beat 86% of fund managers?
The director of London’s Cass Business School summed up active fund management well when he told the Financial Times:
‘A typical investor would be almost 1.44 per cent better off per annum by switching to a UK equity tracker.’
To put that into context, on an investment of £100,000 over 10 years on which a fund manager makes 7%:
- The managed fund will return around £197,000
- A FTSE ETF will return around £225,000
What could you do with that extra £28,000 in your pocket?
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4. Open your eyes to the dark side of the stock market
Dark pools. Mysterious. Deep. Haunting. And an everyday part of the stock market.
Dark pools are where institutions and investment bankers dwell, and private investors are forbidden. But, just like HFT, they’ve been around for decades. In this day of transparent markets, dark pools have floated to the surface of regulators’ concerns.
What is a dark pool?
A dark pool is like a private club. It is a lightly regulated trading exchange, open only to the invited few. They’re run by the large investment banks, like Goldman Sachs. Institutional investors trade millions of shares through dark pools each day. The investment banks take a small commission. They also get to see market moving trades before they happen. And they can use this information (and trades) to hedge their positions or speculate on the market.
Are dark pools fair?
No. They hide important information from private investors. They make a two-tier market.
What are regulators doing about dark pools?
Market regulators like FINRA in the United States have worked hard to make the market more transparent. There are now rules that force dark pools to publish the trades executed in them. So, the good news is that you can now see the trades that have been executed. The bad news is that you won’t see them until two to four weeks after execution.
More bad news is that the orders aren’t public. You can’t see that Institution ‘ABC’ is a seller of a million shares. You’ll only know when the trade has been done and reported.
Are dark pools a help or a hindrance?
Some see dark pools as helping a market to function smoothly. A sale order of a million shares could put downward pressure on a stock if it were made public. Dark pools are seen to protect markets from adverse reactions, as well as help the clients of institutional investors.
However, it could also mean that the price of the open market is not ‘real’. The rules also state that dark pool prices must not be worse than the price available on the open market. So, institutions benefit from the price discovery that naturally takes place in the open. Yet, they don’t reciprocate.
The SEC, FINRA, and other market regulators are continually updating their dark pool regulations. We’ll have to see if this will eventually lead to real-time reporting. If it does, it will probably have a negligible effect on private investors. It might make HFT traders hop around a bit faster, though!
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5. The price on the stock exchange is (almost) never right
In today’s world, information flashes across trading screens at a breakneck pace. Companies must issue news as it happens. When directors either buy or sell shares, they must inform the market. With this real-time news flow, you would expect stock prices to always be on the money. But if they were, stock pickers like Warren Buffett would never beat the market. Yet, they do.
What do stock pickers know that index traders don’t?
There are always opportunities to buy and sell in any market. The reason? Despite living in the information age, stock markets are inefficient. If stock prices reflected the exact value of a company at any given time, there would be little point in either buying or selling shares.
Some people think stocks are overvalued, and others think they are undervalued. This is what makes a market.
Irrational exuberance, or inefficient markets?
If markets were efficient, you wouldn’t need to do any research. That stock with next to no revenues, next to no profit, and trading on a PE ratio of 838? Buy it. Everyone else is.
Investors that believe the market to be efficient become complacent. They neglect to do their research. Instead of buying a business, they buy the flavour of the month. This leads to a stampede mentality, and what ex-Fed Chairman Alan Greenspan famously called ‘irrational exuberance’.
By the way, that stock trading on a PE of 838 – that was Yahoo! Inc. in December 1999. The stock price was $108. Investors didn’t realise the market was inefficient. Instead of buying the business, they bought the stock. They bought on irrational exuberance. Many had lost 95% of their investment within 18 months.
Inefficient markets are great news for self-directed investors
The price on the screen is almost never right. The stock is either undervalued or overvalued. This creates an amazing opportunity for self-directed investors. Do your research and discover the nuts and bolts behind the business. If your research tells you the stock will be higher this time next year, you could bag yourself a bargain.
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This goes for the whole market, too. Markets are driven by sentiment as well as fundamentals. Global shocks cause market meltdowns. That’s the time to think about what that shock really means for individual stocks.
I’ll leave you with this advice from Warren Buffett: