I was reading the WSJ this weekend and thought we should address this market volatility issue. When I say volatility, I mean the frequent ups and downs in the value of your stock portfolio over the last few months. Some volatility in the market is normal – even healthy – but these past couple of months have been one of the most volatile in the history of the Dow going back to the 1800s.
This obviously is unsettling for most investors and I think the following quote in the WSJ by a retired physician in Utah captures the mood:
At this point, he says, he doesn’t have a dollar in stocks, and the odds that he will ever buy another stock are “zero.” Dr. Dixon feels anger and distrust toward the government and the markets alike. “All the Federal Reserve does is look at the stock market and the big banks and figure out how to bail them out with my money,” he says. “Then the bankers pay my money out to themselves as bonuses while the Fed keeps on depreciating all the savings that I worked so hard to build up all these years.” Dr. Dixon adds, “You can shear a sheep many times, but you can only skin him once. And I ain’t gonna lose any more skin.”
Now that guy is mad.
Why is the market so volatile these days? Nobody knows for sure, but there is wide speculation that it’s due to trading done by the computer models that hedge funds and investments banks use. To understand this, let’s go through the changes of the past 30 years or so…
When my father was my age (41), it was around the year 1974. Life was simple back then. (Doesn’t everyone say this?) There were mutual funds, but they were pricey and unpopular. The first index fund didn’t arrive until John Bogle launched the First Index Investment Trust on Dec. 31, 1975 – later renamed the S&P 500 index fund.
My father purchased individual stocks from a stockbroker at one of the many firms in town. Most likely, the broker placed the order by filling out a form and making a phone call. There was no such thing as online trading and there were very few computers!
If my father wanted to find the price of a stock, there were few ways to get a timely quote. No Internet or CNBC. He had to wait for the morning edition of The Charlotte Observer (my hometown paper) to arrive in order to check the stock quotes. If he wanted to know the value of his account, he had to wait for his monthly paper statement to arrive via mail. To hear commentary on the market, he waited patiently for Louis Rukeyser’s Wall $treet Week, which aired every Friday night (once a week!) on PBS.
Back then, individual investors were the primary owners of individual stocks. Large institutions, like pension funds or hedge funds, owned less than 20% of the stock market. If individuals wanted to make a change in their stock holdings, nothing was instantaneous like it is today.
In the 1980s, things began to change. Large institutions’ share of stock-market trading doubled. Some really smart “Quants” figured out how to use these things called computers to develop what was known as program trading (the simultaneous purchase and sale of many different stocks) or of stocks and related futures contracts, with the use of a computer program to exploit price differences in different markets.
On Monday, Oct. 19, 1987 (a.k.a. Black Monday), the Dow dropped more than 508 points (22.61%) in one day. Program trading was largely responsible.
Program trading evolved into algorithmic trading and then high-frequency trading, employed by hedge funds and even individual investors today. In 2006, this black-box trading drove one-third of all EU and U.S. stock trades; by 2009, it was around 60%. This has been the subject of much public debate.
Then, on May 6, 2010, $860B in market value evaporated when the Dow plunged 900 points (9%) in one day. This was known as the “Flash Crash.” In July 2011, a report by the International Organization of Securities Commissions, an international body of securities regulators, concluded that while “algorithms and HFT technology have been used by market participants to manage their trading and risk, their usage was also clearly a contributing factor in the flash-crash event of May 6, 2010.”
Why is this significant? Many believe that high-frequency traders drove these past couple weeks of volatility. In fact, high-frequency traders drove 80% of the trading volume in August and September.
Is this good or bad? If you’re a long-term investor, you should be indifferent. These guys provide liquidity, which is good when you’re ready to buy or sell securities. It’s nice to know there are many participants out there who are more than willing to buy or sell you stocks at any time.
Regardless, large price swings in the stock market have occurred since the beginning of markets. Even before the 1929 crash, the U.S. stock market averaged about two “panics” or large sell-offs per decade in which the stock market dropped at least 20%.
When computers and people have hair triggers programmed to respond to the slightest change in economic conditions, volatility will likely increase. In other words, the majority of the participants driving this volatility care nothing about investing in a business; they are only focused on the possible short term gain or exploitation of price differences. For instance, Wal-Mart’s stock dropped 12% at one point, but nothing fundamentally changed with their business to warrant such a drop. It’s not like the Wal-Mart parking lot was suddenly empty and then investors reacted.
Try not to focus on volatility when you invest in a stock. What you’re doing, fundamentally, is lending a company your capital (i.e., money), to finance the operations of the business. In exchange, you’re requesting a share of that company’s profits (or its losses if things don’t go well).
Sometimes, based on the economic outlook or political situation, the prospects of that business will look very good and people will pay more money for your shares and the value of your stocks go up. When things don’t look as good, people will pay you less.
Over time, however, stocks provide a higher return because you’re getting paid to take on more risk…to weather the volatility. So hang in there. I know the past 10 years haven’t been optimal, but history tells us if you stick it out, your patience will pay off.
Lane Steinberger MBA, CFA, CFP©