Market Makers Make the Market

There is a relatively unknown force that keeps many markets moving, stocks included.  The “market maker” is a pivotal position within most all investment avenues.  A market maker stands ready to buy and sell, possibly at the same time, whatever assets they deal with.  In the case of any specific stock, the market maker will buy at a specified price and sell at a price a little higher.  this spread is where the market maker earns their income.  The benefit to the market is that liquidity is provided.  There may be a small interval in time when there are buyers but no sellers for a stock.  The market maker acts as a buffer here by absorbing that desire to buy by being obliged to sell their own holdings.

Market makers for stocks are typically large banks and investment institutions and are specifically registered as market makers.  They are required to be both a buyer and seller.  This risk is what justifies their reward.  The concept of the market maker goes outside of stocks.  Most commodities are sold through market makers.  Gold and Silver are the two common cases that you may have encountered in your daily life.  If you have ever been to a coin or pawn shop to buy gold or silver, the dealer will generally buy at spot price (market pice) and sell at a small premium above spot.  This is a market making function.  While not as formal as the stock market example, a local market maker will quickly lose business if they are selective about when they buy and sell or if their spread is too high.  Their worth is directly proportional to the amount of liquidity that they provide to their market.

One last note.  With all other factors the same, an increase in liquidity of an asset will increase the value of that asset.  Liquidity is a component of many comprehensive pricing methods.  Think about the difference between a house in an easy to sell area vs a house that may stay listed for a year or more.

A balanced 401k portfolio

Graph GuyThis is one of the most frequent topics that comes up for discussion at Financial Place Online.  What makes for a balanced 401k portfolio?  While there are many different strategies that can be employed, the 401k account is structured differently than a normal investment account.  The 401k is a tax advantaged account, and that is its main and only advantage.  Very few 401k plans offer a great enough variety of funds to try some proprietary investment strategy that a financial advisor will try to cook up for their clients.  Even fewer 401k plans offer low-cost investment options.

The biggest determinant of what you get out of your 401k is what you put in to it.  Doing nothing with all of the great ideas in the world will get you nowhere in investments.  The second biggest factor of 401k success is just being in something other than “cash and cash equivalents”.  This means stocks, bonds, real estate, or even sector funds.  Whatever it is, just be in something.  Also, talk about it and enjoy it.  Have personal ownership for whatever you are in.  The final critical element for success is investing in low cost funds within your 401k.  The fund expense ratio will kill your account if it is high enough.  So much so, that if all of the options have an expense ratio above 1% and the S&P 500 index is the only fund available with a ratio below 0.35%, then be only in that fund.  It makes that much of a difference.  No manager will sustain performance long enough over time to make such a high expense ration worth it.  I see some funds (commodities hedging) flirt with a 2% ratio.  That’s just ridiculous.  Those people should be kicked out of Wall St.

For those who have good low-cost options and want to diversify in your 401k, here’s the Financial Place Online recommendation:

If you have a 401k administered by Vanguard, T. Rowe Price, or Fidelity, then congrats! You have a good bargain of a 401k program.

With that, let’s focus on a well balanced tactic for spreading across the following Vanguard funds, analyzed using their personal account costs.  Your 401k costs should be even lower.

  1. 25% Vanguard 500 Index Fund Admiral Shares (0.05% expense ratio)
  2. 25% Vanguard REIT Index Fund Admiral Shares (0.10% expense ratio)
  3. 25% Vanguard Developed Markets Index Fund Admiral (0.12% expense ratio)
  4. 25% Vanguard Total Bond Market Index Fund Admiral Shares (0.10% expense ratio)

The 25% rule:  Keep the current balance of each of these four account equal at the end of every 4 month period.  This is just often enough to make the changes, but no so much that it becomes too time consuming.  To balance, take your total account balance and divide by four.  Sell any fund that is above this number and use those proceeds to buy more shares of the funds that are below this number.

Automatic, rule based investing is really the way to go.  The costs of anything else goes straight into the broker’s pockets.  Simple 401k investing is something that you should not be paying any advisor for.  That’s why Financial Place Online will never charge for it.  Paid financial advice should be reserved for topics that are more complex, such as small business tax situations, or trust management; certainly not for education on 401k tips and tricks.

The next article from Financial Place Online will feature some analysis of past returns for this investment strategy as well as future expectations.

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