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A reader recently wrote in with the question: “Can you explain bid-ask spreads and why liquidity is important?” And I thought, sure, why not. Part of the appeal of writing these workshop articles is to see if I can explain weird esoteric financial concepts in ways that everyone can understand, and bid-ask spreads are as esoteric as they get, so here we go!
Simply put, a bid-ask spread is the difference between the price you can buy a share vs. the price you can sell a share on the stock market. If you’ve ever been inside an airport, you’ve seen this first-hand at one of those foreign exchange booths where they put up “WE BUY…” and “WE SELL…” prices for various currencies. You’ve probably noticed that those prices are never the same, and are always just a little bit off from the exchange rate that you read about on the news.
Same thing happens with stocks, and just like with those foreign exchange booths, a wide bid-ask spread just ends up costing you money without providing any good reason.
But why do these exist? One word: Liquidity (or lack thereof).
Let me tell you a story. A story about me. In high school.
I Was SUCH a Cool Kid…
When I was in high school, I discovered the Internet and with it a little site called eBay. I was fascinated with eBay, specifically selling stuff on eBay, and specifically selling stuff in a way I could actually make money on eBay.
My poison was computer parts. I would scour local computer stores and trade shows for sales on video cards, hard drives, and memory modules, buy up whatever I could get my hands on, and then resell them over eBay for a profit. I actually got pretty good at it, and at one point my Mom was doing some cleaning in my room when she discovered a shoebox full of hundreds of US dollars in my closet. I actually had to talk her down from thinking I was a drug dealer by showing her how eBay worked, and after assuring her that everything I was doing was perfectly legal, she admitted to being kinda sorta impressed.
And during that time, one of the things I noticed was how important liquidity was to making sure I got a fair price for my item. If something I was selling wasn’t that popular, I had to be REALLY careful what I set my starting bid at because if I set it too low and only one person bid on it, I would accidentally end up selling it at close to my starting price.
But on the other hand, if I knew an item was well-known, I could set my starting bid at anything, including $0.01, and it wouldn’t matter. The item would eventually sell at a fair market price because a bunch of people would all start bidding on it, driving the price up until it saturated at what other people were selling that same item for.
Liquidity: It Keeps Things Flowing
So even in high school, I learned the value of liquidity. Liquidity basically means that if you want to buy something, it’s easy to find someone willing to sell it. Cash, for example, is extremely liquid because everyone is interested in cash. The underwear you were wearing when you TOTALLY met Keanu Reeves on the bus? Not so much.
For financial assets, liquidity is absolutely key. Why? Three reasons:
Price Discovery
When something is liquid, that means there are hordes of people willing to buy it. And like my high school eBay experience, if you don’t have hordes of willing buyers, you have to tell the market what an item is worth. But if you DO have hordes of willing buyers, the market will tell YOU what an item is worth.
Being able to price something at any time means you always know how much your shit is worth, because at any given time you could press a button and have all your assets turned into cold hard cash. And being able to measure how much your portfolio is worth at any given point is crucial to being able to figure out when you can retire. Think about it: your FI number is based on your total portfolio times 4% being equal to your living expenses. But if you couldn’t accurately calculate your portfolio value, then how would you know when you’re ready to pull the trigger? You wouldn’t. And that’s bad.
Trading Volume
When an asset is liquid, that means there’s an active market, meaning there are lots of those assets changing hands every day. And if there’s an active market for it, that means YOU can buy or sell that asset any time you want.
That’s also crucial. If you have a something insanely valuable, like a tyrannosaurus skull, but you can’t find someone willing to take it off your hands, then guess what? It’s not actually valuable. Things are only worth what someone else is willing to pay for it.
A Small Bid-Ask Spread
And finally, we wrap back around to our reader’s initial question: What is a bid-ask spread and why is it important? To explain that, we need to peel back the layer on how exactly the stock market works.
In order to be able to buy and sell stocks so quickly, the stock market relies on something called Market Makers. Market Makers are typically investment banks or brokerages whose job it is to hold a large amount of certain stocks and act as a centralized trader of those stocks. If you want a share of Apple, your order would be filled by Apple’s Market Maker. If you wanted to sell a share of Walmart, you would sell to Walmart’s Market Maker.
But the Market Maker needs to make money to cover its cost of operation. So it will buy a share of a certain stock for, say $100, and then sell it for, say $101, making $1 per share. This is the bid-ask spread.
Now where this relates to liquidity is in that stock’s Trading Volume. If a stock is relatively illiquid, and doesn’t trade that many times a day, a Market Maker needs to increase it’s bid-ask spread in order to make enough money to stay in business. Conversely, if a stock is traded very frequently, the Market Maker doesn’t need to make as much money per trade, so the bid-ask spread narrows.
How Does This Affect Me?
Every few days an email comes into our (completely exploding) inbox asking us whether someone should pick up some obscure penny stock nobody’s ever heard of, and this is the reason we always tell them NO. Even without knowing a single thing about that stock, if it’s not liquid, you won’t get accurate Price Discovery, meaning you have no idea how much that stock is actually worth. You won’t have Trading Volume, meaning if you want to unload it later, there’s no guarantee you’ll find a buyer. And your bid-ask spread will be huge, meaning you’ll lose money every time you trade on it because you won’t be able to get it anywhere near it’s actual market value.
Check out the bid-ask spread you get with a random stock I found mentioned in one of those “STOCK ALERT: BUY THIS NOW” websites:
But for the portfolio we built for this workshop? We did all that homework for you. Because rather than buying individual stocks with questionable liquidity, we used highly liquid heavily traded Index-hugging ETFs. VTI, the Vanguard Total Stock Market Index Fund, for example, changes hands to the tune of 220,000 times a day! And check out the bid-ask spread we can get with this bad boy:
So that’s why small bid-ask spreads are important, that’s why liquidity is important, and that’s why we made sure we have both of those things in our Workshop Portfolio.
And on that note, let’s do our regularly scheduled buys!
Canadian Portfolio
As always, we get a snapshot of our current portfolio allocation, including new cash.
| Asset | Ticker | Unit Price | Units | Market Value | Allocation | Target Allocation |
|---|---|---|---|---|---|---|
| Canadian Bonds | VAB | $25.95 | 96 | $2,491.20 | 36.99% | 40% |
| Canadian Index | VCN | $31.00 | 40 | $1,240.00 | 18.41% | 20% |
| US Index | VUN | $45.38 | 28 | $1,270.64 | 18.87% | 20% |
| EAFE Index | XEF | $30.67 | 32 | $981.44 | 14.57% | 16% |
| Emerging Markets | XEC | $26.18 | 9 | $235.62 | 3.50% | 4% |
| Cash | – | $1.00 | 516 | $516.00 | 7.66% | 0% |
We figure out what we need to do to bring out portfolio back into balance.
| Asset | Ticker | Target Allocation | Unit Price | Current Market Value | Target Market Value | Current Units | Target Units | Difference |
|---|---|---|---|---|---|---|---|---|
| Canadian Bonds | VAB | 40% | $25.95 | $2,491.20 | $2,693.96 | 96 | 103.8 | 7.8 |
| Canadian Index | VCN | 20% | $31.00 | $1,240.00 | $1,346.98 | 40 | 43.5 | 3.5 |
| US Index | VUN | 20% | $45.38 | $1,270.64 | $1,346.98 | 28 | 29.7 | 1.7 |
| EAFE Index | XEF | 16% | $30.67 | $981.44 | $1,077.58 | 32 | 35.1 | 3.1 |
| Emerging Markets | XEC | 4% | $26.18 | $235.62 | $269.40 | 9 | 10.3 | 1.3 |
| Cash | – | 0% | $1.00 | $516.00 | $0.00 | 516 | 0.0 | -516.0 |
And finally, we decide on our orders while being careful not to go into margin.
| Asset | Ticker | Unit Price | Action | Fractional Units | Units | Proceeds |
|---|---|---|---|---|---|---|
| Canadian Bonds | VAB | $25.95 | BUY | 7.8 | 8 | $207.60 |
| Canadian Index | VCN | $31.00 | BUY | 3.5 | 3 | $93.00 |
| US Index | VUN | $45.38 | BUY | 1.7 | 2 | $90.76 |
| EAFE Index | XEF | $30.67 | BUY | 3.1 | 3 | $92.01 |
| Emerging Markets | XEC | $26.18 | BUY | 1.3 | 1 | $26.18 |
| Total | $509.55 |
American Portfolio
Same with our US portfolio. We start with a current snapshot including new cash.
| Asset | Ticker | Unit Price | Units | Market Value | Allocation | Target Allocation |
|---|---|---|---|---|---|---|
| Bonds | BND | $81.94 | 30 | $2,458.20 | 36.48% | 40% |
| US Index | VTI | $123.54 | 15 | $1,853.10 | 27.50% | 30% |
| International Index | VEU | $50.28 | 37 | $1,860.36 | 27.60% | 30% |
| Cash | – | $1.00 | 567.75 | $567.75 | 8.42% | 0% |
We calculate our rebalance operations.
| Asset | Ticker | Target Allocation | Unit Price | Current Market Value | Target Market Value | Current Units | Target Units | Difference | |
|---|---|---|---|---|---|---|---|---|---|
| Bonds | BND | 40% | $81.94 | $2,458.20 | $2,695.76 | 30 | 32.9 | 2.9 | |
| US Index | VTI | 30% | $123.54 | $1,853.10 | $2,021.82 | 15 | 16.4 | 1.4 | |
| International Index | VEU | 30% | $50.28 | $1,860.36 | $2,021.82 | 37 | 40.2 | 3.2 | |
| Cash | – | 0% | $1.00 | $567.75 | $0.00 | 567.75 | 0.0 | -567.8 |
And finally, we decide on our order quantities being careful not to go into margin.
| Asset | Ticker | Unit Price | Action | Fractional Units | Units | Proceeds |
|---|---|---|---|---|---|---|
| Bonds | BND | $81.94 | BUY | 2.9 | 3 | $245.82 |
| US Index | VTI | $123.54 | BUY | 1.4 | 1 | $123.54 |
| International Index | VEU | $50.28 | BUY | 3.2 | 3 | $150.84 |
| Total | $520.20 |
And we’re done for the week! Thanks everybody, and see y’all next week!
Continue onto the next article!
WORKSHOP TOOLS
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Disclaimer: The views expressed is provided as a general source of information only and should not be considered to be personal investment advice or solicitation to buy or sell securities. Investors considering any investment should consult with their investment advisor to ensure that it is suitable for the investor’s circumstances and risk tolerance before making any investment decisions. The information contained in this blog was obtained from sources believe to be reliable, however, we cannot represent that it is accurate or complete.
Excellent explanation on the well known common mysterious word of “Spread”. Day by day i am learning new meanings of these investment concepts.
Keep up the good work
Interesting, I never really paid attention to the whole bid and ask section on Questrade, I just assumed the bid is what people were willing to pay and the ask is what people were willing to sell for, so I always used the “ask” figure when I wanted to buy something.
I guess in simple terms that is what it is, but I had no idea I was buying and selling to some middle man market maker when I was making a transaction. I suppose when you’re only dealing with large ETF’s it’s not a major concern as the risk is pretty low, but as you point out when dealing with penny stocks it’s a huge concern so maybe one day it will be good to know!
Yup, the Market Makers’ job is to provide instant liquidity for anyone who wants to trade. If every time you traded you were matching up to some other individual seller, you would get wildly fluctuating prices.
I had almost the same story with a shoe box full of Russian Rubles. It was 2002 and I heard about WAP (sites for mobile phones). I was interested in and found a book that taught me some basic xml and php. So after couple of sleepless weeks I created my very first mobile site where I was selling mobile apps, games, pictures and videos.
After couple of years I had a lot, A LOT of money, but I was dumb and kept them in liquid Rubles and lost almost everything during the Russian economy down. But that was a fun experience.
Ah the ruble fluctuation is crazy… that’s why alot of expats have left Russia and Moscow, their earning power went down by 40-50%… If you have US or Canadian dollars though then everything is super cheap.
Really? Huh. Maybe we should go visit Russia…
Getting the Russian tourist visa is a long process for foreigners though…Europe is much easier, just need your passport. But Russia is a fascinating place.
Great explanation. Outside of my tax-sheltered accounts, I mostly trade ETF’s (and mostly strictly for tax-loss harvesting, between like-funds. I do pay attention to the spread, and so I like to stay with ones that have high transactional volume.
Hi, enjoyed the emphasis on the importance of liquidity. When showing the changes in portfolios, is the American Portfolio just an example for American’s? or do you actually hold an American portfolio plus your Canadian Portfolio? Curious because I am in the process of setting up my own.
The American one is the example for Americans and the Canadian one is the example for Canadians, but I actually hold both in the amounts listed. Those are real portfolios.
I am fairly new to investing. I sold my house last year and invested along Garth Turner’s philosophies. My question is on rebalancing. I copied my holdings below and as you can see, nice gains on some. This is since September. How would one rebalance? Would I actually sell some stocks from the gainers and buy the losers? Or do I merely buy the lowest one from proceeds of the dividends. I am still working so I do not take out money from this account. I would appreciate any advice I can get. Thank you.
VANGUARD SP 500 INDEX… VFV 58.56* 500.00 25,060.00 29,280.00 +4,220.00 +16.84%
Vanguard FTSE All-World… VXC 35.21* +0.15 800.00 24,160.00 28,168.00 +4,008.00 +16.59%
Claymore S&P/TSX… CPD 13.64* 1,500.00 19,080.00 20,460.00 +1,380.00 +7.23%
Claymore Canadian… FIE 7.03* 3,000.00 20,190.00 21,090.00 +900.00 +4.46%
iSHARES SP TSX NA PREF… XPF 18.21* 1,100.00 19,613.00 20,031.00 +418.00 +2.13%
iShares Diversified… XTR 11.47* 1,700.00 19,363.00 19,499.00 +136.00 +0.70%
VANGUARD CDN AGGREGATE… VAB 26.03* 1,700.00 44,354.50 44,251.00 -103.50 -0.23%
crickets….. 🙁
We wrote an article about rebalancing here:
https://www.millennial-revolution.com/invest/rebalancing-how-to-buy-low-and-sell-high/
Great insight to something many casual investors probably aren’t aware of. Another reason why not having a plan or having a bad plan can hurt the every day investor.
Jordan @ New Retirement