Some intraday data series do not contain a buy/sell identifier for trades. As most estimators of transaction costs require this information, an algorithm is necessary to classify trades as buy or sell. When bid/ask quotes (or best buy/sell limit order prices) are available, a natural method is to compare the trade price with the quotes prevailing at the time of the trade. Trades at or above the ask (or best sell limit price) will be classified as buys, trades at or below the bid (or best buy limit price) will be classified as sells. This algorithm will leave trades within the quotes unclassified. Trades within the quotes may be either ‘crosses’ (trades negotiated outside the central market place) or trades where a floor broker or the order book improved on the price of the specialist’s quote, as often happens on hybrid markets like the NYSE. Lee and Ready (1991) show that this algorithm is very reliable and classifies most trades in the same way as the classification based on a comparison with bid and ask quotes.

Empirical research on the microstructure of exchanges ordinarily uses intraday price and trade data. However, the format and quality of the data differ greatly by exchange and data source. For measuring quoted spreads, a record of simultaneous bid and ask quotes is needed. In dealership or hybrid markets (with a designated specialist or market-makers with quote obligations), such data are sometimes available. However, one needs to be careful because the quotes may only be indicative (as they are, for example, in the foreign exchange markets) or there may be better prices available from a competing order book.

For the other measures discussed, prices of actual transactions are needed, and typically one also needs to know whether the transaction was initiated by the buyer (‘buy’) or by the seller (‘sell’). For some markets, this classification into buys and sells is easy to establish, since trading is at best quotes or the best prices available in the limit order book (LOB). An important exception is the NYSE, where trading can be within the specialist’s quotes, because either the specialist improves on his quoted price, or trading is with the LOB. Moreover, the NYSE data sources (notably the TAQ database) have two separate files for trades and quotes and the timing is not exactly simultaneous.

This sometimes makes it difficult to classify a trade as buy or sell. Lee and Ready (1991) developed a classification method that has become the standard measure for the TAQ data. In recent years, many high-quality data sets have become available from electronic limit order book markets, where all trades are cleared against the limit order book. This permits unambiguous classification of trades as buys or sells.

The measures of the spread discussed above require observations on transaction prices and bid–ask quotes. Very often, however, quoted prices are either unavailable, unreliable or difficult to handle. As noted, quotes may not be binding or the spread may vary in the course of the trading day, so estimation of the spread based on transaction prices is usually preferred. Roll (1984) offers a very parsimonious model for estimating spread, using the time series of the prices at which trades were made. This model shows that when transaction costs consist of order processing costs only, i.e. in the absence of both adverse selection and inventory costs, the quoted spread coincides with the realized spread.

Roll demonstrates that it is possible to estimate spread by computing the autocovariance of transaction prices. Below we show how in the absence of transaction costs this auto-covariance is equal to zero, whereas with transaction costs, it is negative and a function of the spread. This allows us to estimate the spread by using transaction prices alone. This method proves useful when quoted bid and ask prices are not available.

on account of market microstructure frictions, transaction prices may deviate from the equilibrium price, generating transaction costs. As we have noted, the bid–ask spread is a frequently used indicator of market liquidity. This differential is an important component of trading costs, often referred to as implicit transaction costs to distinguish them from explicit costs such as brokerage fees and taxes. We will offer different measures of the spread, each one focusing on a different interpretation.

The quoted spread, or the difference between the best ask and best bid prices offered by liquidity suppliers, is an estimate of the costs that a generic investor incurs for a round-trip transaction, i.e. a purchase followed by a sale. On the other hand, the realized spread is an estimate of the gain a market-maker can expect to make from two consecutive transactions. We show that the two definitions coincide when transaction costs consist solely in order-processing costs. We will also show that the difference between the quoted and the realized spread, which is always positive or at least zero, is a positive function of adverse selection and inventory costs. This difference can also be affected by the number of transactions at prices within the spread, as well as by order fragmentation. Furthermore, we will provide a definition of the effective spread, which is twice the difference between the transaction price and the midpoint of the quoted bid–ask spread and is therefore a better proxy of transaction costs when quoted prices are not binding.

Socially responsible mutual funds are an extreme example of asset gatherers using your values and neediness to turn you into a profit center for them. Socially responsible funds buy companies that they deem good corporate citizens or that follow certain religious or moral guidelines. They tend to avoid tobacco stocks, companies that discriminate or do not hire union workers, firearms and weapons manufacturers, and companies that pollute the environment.

While you are under the illusion your money is doing good, mutual fund companies operate on the hard fact that socially responsible fund investors do not trade funds and have low standards for investment return. These funds all buy the same stocks and produce the same mediocre returns, but their asset bases grow steadily. In recent years, socially responsible funds have been among the fastest growing asset gatherers. More importantly, your investment does not go directly to the company doing “good.” Your cash is used to buy shares from other stockholders who are tired of the company. A direct investment in a socially responsible enterprise or in a public offering of new shares is rare. When you discover that your money is enriching fund managers, not you or your causes, you may feel betrayed. If stocks are outside your comfort zone, you will feel better giving directly to the endeavor you support and investing the rest of your funds within your comfort zone.

Fund organizations run many funds. They call themselves fund “families.” Studies show that marketing, not high returns, increases funds under management over the long-term. The fund families send you newsletters and have Web sites. Every article is designed to encourage you to ignore the results you have gotten and buy more product. Your mailbox will also be stuffed with bulletins about new funds, account statements, proxy statements, and tax statements. The more money you have with the family, the higher the level of service and status you can achieve within the family. You can move up from ordinary to preferred to gold to platinum to admiralty. Switching funds within the fund group is convenient and quick. To switch from a rival fund, they will even do all the paperwork for you. But moving out of the family is discouraged. If you are dissatisfied with one of their funds, they hope your sense of loyalty and desire for convenience will cause you to buy another fund within the family. Retaining your mutual funds is their primary goal.

Some funds close to new investors. This gives existing investors the illusion that they own an exclusive product, which discourages them from selling. Some funds also impose penalties for early withdrawals. This keeps your money under management and creates a steady income stream for the und manager.

As with any good dysfunctional family, there are many secrets. You cannot find out what stocks your fund owns more than every six months, and then only 45 days after the six-month period ends. Nor can you get any information explaining why one manager was fired and another hired. Even mutual fund watchdogs such as Lipper and Morningstar cannot obtain this information. It is as if this is not your money but the family’s money.

If you have family abandonment issues, mutual fund investing will be troublesome. Seeking approval and support for your emotional deficiencies will cause you to stay with poor funds when better returns are available elsewhere. Severe depression could follow.

Fund organizations run many funds. They call themselves fund “families.”  Studies show that marketing, not high returns, increases funds under  management over the long-term. The fund families send you newsletters  and have Web sites. Every article is designed to encourage you to ignore  the results you have gotten and buy more product. Your mailbox will also be  stuffed with bulletins about new funds, account statements, proxy statements,  and tax statements. The more money you have with the family, the  higher the level of service and status you can achieve within the family. You  can move up from ordinary to preferred to gold to platinum to admiralty.

Switching funds within the fund group is convenient and quick. To switch  from a rival fund, they will even do all the paperwork for you. But moving  out of the family is discouraged. If you are dissatisfied with one of their  funds, they hope your sense of loyalty and desire for convenience will cause  you to buy another fund within the family. Retaining your mutual funds is  their primary goal.

Some funds close to new investors. This gives existing investors the  illusion that they own an exclusive product, which discourages them from  selling. Some funds also impose penalties for early withdrawals. This keeps  your money under management and creates a steady income stream for the  fund manager.

As with any good dysfunctional family, there are many secrets. You  cannot find out what stocks your fund owns more than every six months,  and then only 45 days after the six-month period ends. Nor can you get any  information explaining why one manager was fired and another hired. Even  mutual fund watchdogs such as Lipper and Morningstar cannot obtain this  information. It is as if this is not your money but the family’s money.

If you have family abandonment issues, mutual fund investing will be  troublesome. Seeking approval and support for your emotional deficiencies  will cause you to stay with poor funds when better returns are available  elsewhere. Severe depression could follow.

The personal change process is harder than the process described in this book. Outside help is necessary. You deserve to have a happy investment life just as you deserve to have a happy relationship. To achieve personal change, you can commit yourself to a codependence treatment program, see a psychiatrist, take prescribed medication, go to a trained psychologist or therapist, attend group psychotherapy, commit to Gamblers Anonymous, and enlist the support of family, friends, and work colleagues.

But you must get help. You cannot fix yourself. You cannot use a broken tool to fix a broken tool. The input of trained professionals and those who have recovered is absolutely necessary.

For most of you, however, Step 1 is the entryway to your comfort zone.

You will notice that in this second stage there are no stocks, options, futures, metals, rare coins, or derivatives in the portfolio. And there is a good reason for that. When you have less than $100,000 to invest and less than a long time to get rich, you should focus on only two things:

1. Continuing to increase your income by continuing to perfect a financially valued skill such as selling, marketing, product development, or profit management

2. Investing the surplus in high-return equity ventures If you focus on this for a few years, chances are that you’ll end up with a surfeit of cash—that is, more cash than you need for your side business and real estate ventures. This extra cash should be kept safe. Extra safe. Remember, this is the beginning of your retirement nest egg. So place this surplus cash in bonds, and reinvest the interest in bonds, too. Make it a primary objective to have this safety reserve grow substantially every year. Once your bond savings become significant, you’ll start to appreciate what a valuable, comforting investment bonds can be.

You could, for example, create a side business selling a skill you currently have (accounting, legal, writing, editing, purchasing, etc.) or could develop (graphic design, copywriting, resume writing, etc.). Or you could turn a hobby or passion (stamp collecting, gardening, pets) into a profitable, Internetbased direct-marketing business.

As your side business grows, it will require that you reinvest some of the profits into creating new products, hiring employees, and developing new advertising campaigns. You should allow for growth, but limit it to avoid growing so fast that you end up losing control and getting into trouble.

Equity-building real estate. Buying equity-building real estate means buying rental properties. The trick to making this work for you at this second stage of wealth is to buy conservatively— that is, to make sure that the rent you’ll get will at least meet (but should really exceed) your cost of maintaining the property. I recommend duplexes, triplexes, and quadruplexes to start. They’ll give you the best chance to achieve zero or positive monthly cash flow. How much equity-building real estate should you develop? If you have a net worth of $100,000, I’d recommend a little more than half. Let’s say $60,000.

Fixed-income instruments. The rest of your money should be in Treasuries, municipal bonds, or quality corporate paper. Fixedincome instruments like these don’t provide a high return, but they are safe.