Bid-ask spreads can eat up your dollars
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The Goldilocks Investing NewsletterNo. 7Oct. 13, 2016
Welcome to our occasional newsletter! Today's issue is designed for people who attended a recent beta-test Goldilocks Investing seminar in Boston, Seattle, or elsewhere.

Please do not forward this newsletter to others. Our book on investing is in stealth mode, and people who did not attend a seminar would be baffled by the following discussion. Please don't share this information until the book is released in 2017.

See trading costs of major ETFs for free

Brian LivingstonBy Brian Livingston

One little-known fee can seriously eat into your investing returns. Now our website makes it possible for you to see these costs before you buy or sell. This can help protect you from "flash crashes."

The fee is technically known as the bid-ask spread. The bid price is what someone will pay to buy from you one share of a stock or an exchange-traded fund (ETF). The ask price is what you get if you immediately turn around and buy that share again.

For example, the bid price at which you can sell one share of an ETF might be $49.90. But the ask price if you wanted to buy the share would be $50.10. In this case, the bid-ask spread is 20 cents per share or 0.4% (that's $0.20 divided by $50.10).

People who frequently trade can underestimate how much costs like these are hurting them. The one-fifth of investors who traded the least earned 18.5% annualized from 1987 through 1993, according to a 2000 study. The one-fifth who traded the most earned only 11.4%. The difference was entirely due to bid-ask spreads, commissions, and market effects (prices moving away from you when you trade).

Trading fees are lower now than they were in the 1990s. But any time you can reduce your costs, you keep more money in your pocket. 

The good news is that the heavily traded ETFs in the Goldilocks Investing portfolios generally have very small bid-ask spreads. Some ETF spreads are as low as 1 cent or less than 0.01%, centered around the "midpoint price." You lose half the spread when you buy a security and the other half when you sell. Each bite is sometimes called the one-way spread.

The bad news is that even the most-popular ETFs can have ridiculously high spreads during the first few minutes of trading or a "flash crash." Our website now helps you see and avoid these costs.
Bid-ask spreads in the Mama Bear Portfolio
Figure 1. The orange arrow points to our new bid-ask spread column. Spreads below 1.0% indicate an orderly market, when it's safe to buy and sell major ETFs.
 
In normal times, ETF spreads are less than 1.0%

I've added bid-ask spreads to the price charts at Goldilocks-Investing.com to alert you to "flash crashes" that make trading dangerous. The numbers are computed by ETFScreen.com, an excellent source of information on ETF trading strategies.

Like all of the other numbers in our price tables, the bid-ask spreads are updated every 10 minutes while the market is open. Simply press F5 (Windows) or Command+R (Mac) to refresh your browser window, when necessary.

Figure 1 shows the new column in the Mama Bear Portfolio table. The Papa Bear Portfolio also has this column.

Flash crashes are rare but dangerous. The British pound suffered a dive of more than 6% within six minutes last week before recovering somewhat. That was a sudden currency crisis, and it didn't affect most ETFs. But some ETFs are vulnerable to other flash crashes.

The worst case involving ETFs occurred in August 2015, when China unexpectedly devalued the yuan. Some investors panicked and placed orders over the weekend to sell massive quantities of ETFs.

Facing five times the normal level of sell orders, the NYSE temporarily suspended a rule requiring the immediate publication of security prices. When the market opened on Monday, one "smart beta" ETF fell 45% at the open, only to recover within the first 30 minutes of trading. I explained flash crashes in the Aug. 30, 2015, newsletter.

During a flash crash, bid-ask spreads rise to ridiculous levels as market makers inflate prices to ensure their profits. You can protect yourself against these disorderly markets as follows:

Never place "market orders" while the market is closed or during the first 60 minutes of the trading day. Spreads are highest in the morning, which traders call "amateur hour." Market makers can charge you a ridiculously expensive spread in the first few minutes, if that's necessary to clear an imbalance of orders.

Buy or sell an ETF only if its spread is under 1.0%. This is the purpose of our new spread column. Commodity and bond ETFs sometimes have spreads of 0.1% or 0.2%. Other ETFs have spreads of only 0.01%. Any level below 1.0% is a sign of an orderly market.

Don't buy or sell an ETF whose spread is over 1.0%. This is a sign that a flash crash may be occurring. Check back an hour later and buy when spreads have returned below 1.0%.

Don't assume limit orders solve the problem. A "limit order" says you'll buy shares of XYZ for no more than, say, $50.10. If XYZ opens at $30, a market maker would happily fill your order for $50.10, pocketing an outrageous 67% spread.
 
Be careful with spreads you see on other websites

If you see at our site that spreads are over 1.0%, you can look up a quote, for example, for VWO or any ETF at Yahoo Finance. A news story there might indicate what is roiling the market, such as a sudden financial crisis.

I believe it would be ridiculous to make you go to a second site when Goldilocks-Investing.com can now be checked at a glance. That's why the spread column is a new, permanent feature of our price tables. If you do look up spreads at other sites, though, here are some cautions:

The site might not calculate the spread for you. Yahoo, for instance, shows only the raw bid and ask prices. You have to do the calculation yourself.

Spreads may be delayed. It's typical for online bid and ask prices to run 20 minutes or more behind real time. Every spread that's calculated at Goldilocks-Investing.com is delayed approximately 20 minutes, which should be fine for investors who trade no more than once per month.

Spreads are wildly off when the market is closed. You should check bid-ask spreads on Yahoo Finance and other financial sites only between 10 a.m. and 4 p.m. Eastern. When the market is closed, spreads can be astronomical. I've seen spreads of more than 7.0% for ETFs in the thinly traded after-market. All of the numbers in our tables are "frozen" at 4 p.m. Eastern to give you a realistic estimate of the market day's spread. Most investors can't trade in the after-market, anyway, but must wait until the next trading day starts.

Spreads will very seldom be a problem for the ETFs in the Mama Bear and the Papa Bear. These ETFs are some of most popular and heavily traded in the world. But now you know what to look out for if the market ever does become abnormal.
 
Goldilocks Investing will change to Muscular Portfolios

Some time in the next few weeks, the Goldilocks-Investing.com site will change to its new domain name: MuscularPortfolios.com. You'll receive a newsletter on that date to alert you to the change. Links to the old domain should automatically redirect to the new one.

Goldilocks Investing was always a "working title" for my forthcoming book. The permanent title will be Muscular Portfolios: Reduce Your Risk to Improve Your Investing Gains. (The subtitle is still open to improvement.)

The book will still use the tale of Goldilocks as a metaphor. The goal is to help you find investing strategies that are "not too risky, not too tame, just great gains." This is explained in my new freebie, which you can get at the link below.

The book's release date is still some time in 2017. You'll be the first to hear about special deals in this newsletter. Stay tuned.
 
Free stuff you might enjoy

If you've read this far, your reward is a downloadable layout of "The Tale of Goldilocks and the Three Bankers." This is the first two pages of the very first section of the book.

For a limited time, you can download a rough image file (definitely not the final design or edited version) at:

The Tale of Goldilocks and the Three Bankers

You can still get a one-page PDF that summarizes the whole book free of charge at:

Goldilocks Overview

If you missed any of our previous newsletters, links to them can be found in the lower-right corner of our home page.

If you have comments to contribute, start a new message to a special address that goes directly to me:

MaxGaines "AT" BrianLivingston "DOT" com

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About the author: Brian Livingston is the author of the forthcoming book Muscular Portfolios (2017). He is also the co-author of 11 books in the Windows Secrets series, 1991–2007 (John Wiley & Sons), with over 2.5 million copies sold. From 1986 to 1991, he worked in New York City as assistant IT manager of UBS Securities; a consultant for Morgan Guaranty Trust (now JPMorgan Chase); and technology adviser for Lazard Frères (now Lazard Ltd.). He was the weekly Windows columnist for InfoWorld magazine from 1991 to 2003. During portions of that period, he was also a contributing editor of CNET, PC World, eWeek, PC/Computing, Datamation, and Windows magazine. In 2003, he founded the Windows Secrets Newsletter, which grew from zero to 400,000 email subscribers. He served as its editorial director until he sold the business in 2010. He is currently president of the Seattle regional chapter of the American Association of Individual Investors (AAII).

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This newsletter and the information contained herein are impersonal and do not provide individualized advice or recommendations for any specific subscriber or portfolio. Investing involves substantial risk. Neither the publisher of this newsletter, its authors, nor any of their respective affiliates make any guarantee or other promise as to any results that may be obtained from using the newsletter. While past performance may be analyzed in the newsletter, past performance should not be considered indicative of future performance. No reader should make any investment decision without first consulting his or her own personal financial adviser and conducting his or her own research and due diligence, including carefully reviewing the prospectus and other public filings of the issuer. To the maximum extent permitted by law, each author, the publisher, and their respective affiliates disclaim any and all liability in the event any information, commentary, analysis, opinions, advice and/or recommendations in the newsletter prove to be inaccurate, incomplete, or unreliable, or result in any investment or other losses. The newsletter’s commentary, analysis, opinions, advice, and recommendations represent the personal and subjective views of the authors, and are subject to change at any time without notice. Some of the information provided in the newsletter is obtained from sources which the authors believe to be reliable. However, the authors have not independently verified or otherwise investigated all such information. Neither the publisher, its authors, nor any of their respective affiliates guarantee the accuracy or completeness of any such information. Neither the publisher, its authors, nor any of their respective affiliates are responsible for any errors or omissions in this newsletter.

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