In Texas, there are a lot of highways that have just two lanes of traffic in each direction, just like the 101 traveling through Montecito. It is very common to see signs along these highways that read; “Slower Traffic Keep Right.” These signs alert drivers of the need to stay in the right lane unless they are passing someone. This helps speed the flow of traffic and avoid traffic jams that occur when drivers sit in the left-hand lane blocking faster traffic. (By the way, this is a huge pet peeve of mine, and I wish California would use the same signs.) While this message is intended for commuters, I think it applied equally well to investors, especially these days, with such extreme market volatility.
Recently 60 Minutes aired a show on high-frequency trading. High-frequency trading, in simple terms, involves computer programs that look for certain indicators or inaccuracies in securities trading markets, and, when they find one, blast-off orders for a huge number of shares, getting in and out in seconds, trying to profit only by pennies per share traded. These pennies add-up when we are talking about millions of shares traded, and can be highly lucrative. However, the trades also increase volatility dramatically, both for the individual security traded, and for the market overall, especially if you have many high-frequency traders all trading at the same time, based on the same or similar indicators.
The problem of high-frequency trading, and the reason it is so controversial, is that, when we have periods of trading where the market moves down significantly over a short period of time, high-frequency traders identify opportunities to participate in that downside by throwing a massive amount of volume at the market, essentially kicking it while it is down. Often this accelerates the downward move in the market (or an individual security), which can cause wide spread panic, resulting in even more selling pressure.
There have been some who have called for eliminating high-frequency trading, and all program-based trading for that matter. We saw a similar reaction to the 1987 stock market crash, which initially was blamed on program trading, although this particular type of program trading was insurance-based and not speculative—programs had been developed that were supposed to protect large institutional portfolios from downside risk beyond certain parameters by automatically selling securities if the market fell by a certain percentage or by a certain amount, or by buying put options on indexes, such as the S&P 500, to provide a hedge against further losses. When the stock market crashed, these programs were triggered, resulting in even more selling and greater losses overall for the stock market.
My feeling is that markets should be allowed to trade freely, regardless of volatility. Since I consider myself to be an investor, as opposed to a speculator or trader, I am not so concerned with daily fluctuations, other than when they present opportunities for me to purchase securities at attractive prices. Volatility is not a bad thing, per se, although it can serve to confuse some investors, and can create a lot of “white noise” meaning that the longer-term trend can sometime be obscured by the day-to-day action of the markets.
A true long-term investor should not be swayed by daily volatility. Instead, each investor should have a well thought-out investment strategy based on their true, long-term objectives and risk tolerance, which should not change, based on short-term fluctuations in the market. If followed, this long-term strategy should keep the investor focused on their long-term goals, and should prevent them from making rash decisions or panicking, based on any short-term declines that may be caused by speculators, high-frequency traders, et al. Easier said than done!
I realize that, in the heat of battle, sometimes it is difficult to understand whether the volatility we are experiencing day-to-day is a consequence of short-term speculation, or is an indicator of a more significant economic or financial market trend that will have long-term, negative implications for portfolios. Herein lies the rub. How can we accurately determine whether a short-term downward move in the markets is just that, a short-term event, or if it is the beginning of a significant market correction or bear market?
This is a complex question with no right or wrong answer and no single right answer. I can only comment on what I do to address this challenge, although there are many experts out there that have varying ways of doing so. I rely on my analysis of the current and future trends I see developing within the U.S. and world economies, and the U.S. and world financial markets. That is a really broad and general answer to a very specific problem, I know!
More specifically, I conduct a lot of research on what is happening within the U.S. economy and financial markets primarily, and additional research on how foreign economies and markets will affect the U.S. economy and financial markets. What I attempt to determine is where we are now, in terms of the economic cycle, and then, based on my analysis of the current and future situation, and adding to that what typically happened during similar economic times in the past, where the economy is heading over the next 3 to 5 years. From that general overview, I then try to identify those sectors of the economy that I feel will perform best, given my analysis and forecast for the economy. I also look at each sector to see how it has performed historically, at similar times in the economic cycle, with similar commodity prices, similar interest rates, similar political environments, etc., etc. This is, of course, not always possible, since there may not be a comparable situation for each of these variables.
Once I have completed all analyses and comparisons, I develop my strategy by deciding what percentage of a portfolio, based on the investor’s objectives and ability to assume risk, should be invested in the various asset classes—their appropriate asset allocation. Once this has been determined, I then decide how I want to divide-up the assets into sub-categories, based on my expectations for the future performance of the U.S. economy and the various sectors within the economy. Those sectors I believe will outperform in the coming environment will be over-weighted as compared to their historical averages, while those economic sectors that I believe will not perform well will be underweighted or not weighted at all.
Once the overall strategy has been defined and the initial investments have been made according to my determinations for the economy, etc., I then monitor the performance of portfolios against my expectations and the changing investing environment. When changes are required, I update portfolios to accurately reflect those changes, always maintaining proper alignment with the investor’s stated objectives and risk tolerance.
There are many strategies available to investors, and what I have described above is a simplified explanation of what I do on a daily basis for my clients. The important point is that each investor needs to identify the most appropriate strategy for their portfolio that not only makes sense to them, but also has at least the potential to generate the kind of returns that are commensurate with the risks taken. Most importantly, a well-conceived and executed investment strategy can be the one thing that keeps the investor focused during short-term declines, and prevents he or she from panicking at the worst possible time. My best advice to true investors is “Slower Traffic Keep Right”—let those who wish to speculate have the fast lane and pass you by. We will see most of them stranded on the side of the road after they run out of gas.