“It was the best of times, it was the worst of times.” — Charles Dickens
The conventional wisdom is that today is the “worst of times” for investors. Michael Lewis, an author promoting his book “Flash Boys” in 2014 that explored the world of high-frequency trading, claimed that the “stock market is rigged.” Others say that the “golden age of investing” is over, replaced by a new normal of lower investment returns and the end of an era of outperformance by star portfolio managers.
The tendency of individual investors to underperform relative to market indices is an often-cited problem, with the financial media unsurprisingly taking some of the blame. Despite a narrative that frequently accentuates the negative, a case can be made that today’s market offer elements of “best of times” and “worst of times.”
Trading
The worst of times. Lewis identified some of the seamier aspects of high-frequency trading. Investors are dismayed that some traders receive market-moving information milliseconds before other market participants and are able to exploit that information advantage. Electronic trading firm Virtu disclosed that it had only a single unprofitable trading day between 2009 and 2014, raising eyebrows throughout the industry. Industry insiders say that Virtu isn’t the only firm with such consistently positive results. Also worrying is the increased frequency of “flash crashes,” rapid and unexplained falls in security prices in very short periods of time.
[See: 9 ETFs to Buy When the Market Tanks.]
The best of times. Market making has been a lucrative activity since the New York Stock Exchange was founded under a buttonwood tree on Wall Street, and complaints about trading costs and front-running have been a constant throughout the history of investing. However, equity trading costs have steadily declined in recent decades, and are lower today than they’ve ever been. Until 1975, commission rates were fixed at a multiple of today’s $8.95 per trade (or lower) offered by retail brokers. Bid-ask spreads were also far higher in that era, and have come down substantially courtesy of the May Day “de-regulation” in 1975, and decimalization implemented in 2001 that changed trading increments from 1/16 to a penny. Most investors would much rather trade at today’s commissions and bid-ask spreads than under the trading environment of past periods in the market.
End of the Golden Era of Investing
The worst of times. Stocks and bonds provided strong growth over the past 35 years, propelled by favorable demographics, corporate profits fattened by globalization, and falling inflation. Some of the most successful portfolio managers became media stars as investing entered the mainstream. The investment outlook is much more subdued today, as positive mega-trends that were tailwinds for decades appear to be at an end.
Demographic trends are negative in much of the world, as the working age population ages and dependency ratios rise. Benefits from globalization appear to have peaked and populist movements will likely cause a slowing or retrenchment of global trade. Inflation declined dramatically from the early 1980s, and has fallen so much in recent years that deflation is considered the greater risk. All signs indicate that 4 percent to 6 percent growth in the stock market may be the new normal, below what investors expect.
The demise of the star portfolio manager is in part a function of the end of the golden age of investing as long-term positive trends lose momentum. Vigorous competition among investors and increased transparency may also contribute to the demise of the star manager. Simply put, it may just be harder to “win” in the markets.
The best of times. The rising tide hasn’t lifted all boats, as revealed by studies that show the poor results for individual investors relative to market benchmarks over time. Many investors have lagged market benchmarks by following conflicted advice from intermediaries, timing the markets poorly or investing in high-priced, poorly managed active funds. Although the new normal may be for lower returns, individual investors have a wider array of investment alternatives and advice options that may improve their performance relative to the broad market.
[See: 7 Notable Quotes From Warren Buffett.]
Price competition and awareness has come to the investment industry. Mutual funds with high sales loads are losing popularity and are in retreat. Exchange-traded funds, an investment option that didn’t exist 25 years ago, are in a “race to zero” with price competition taking expense ratios close to zero for several of the most popular index ETFs. Low-cost actively managed products are also available, from firms such as Vanguard, American Funds and Dodge and Cox that are admired for their high-quality offerings and low costs.
Twitter and 24-7 Business News
The best of times and the worst of times. Before investing became something of a spectator sport, there was limited information available about the markets. Lewis Rukeyser’s public broadcasting show, “Wall Street Week, was “must-see TV” for professional and amateur investors, and the primary source for investors to check stock prices was the newspaper. Corporations provided limited information to the public, though in private provided considerable information to favored analysts and investors.
The world is much different today, with positive and negative consequences. Market news and commentary is available 24 hours a day, seven days a week. The “noise” includes a non-stop stream of tweets from Twitter and commentary from various television networks and market-oriented websites. Regulation fair disclosure ended practices in which favored analysts or portfolio managers were given “guidance” to inform their estimates, in some ways leveling the playing field for investors but in other ways making companies more guarded about their statements. Distinguishing between noise and material information is difficult even for professional investors.
Investors have a wealth of information supporting their research efforts, which is mostly a good thing. The quantity of information, transparency of corporate results, and level playing field for information support the decision-making process. However, 24-hour coverage of markets encourages some unfortunate investor behavior. The constant stimulus from never-ending news cycle encourages investors to trade too much and needlessly heightens anxiety. Consequently, the 24-7 world of today provides both benefits and risks, and makes this the best and worst of times for investors.
What to Do?
Use good trading “hygiene.” Markets are most volatile in the first and last half hour of the trading day. Many investors avoid trading during the opening and closing 30 minutes, avoiding the heightened volatility while professional traders are circling each other to determine opening and closing prices for securities. Investors can also protect themselves from possible flash crashes by using limit orders at all times, rather than market orders that may create more risk in a flash crash or turbulent market.
Create a diversified portfolio, being mindful of costs and taxes. A diversified portfolio offers a better balance of risk and return than concentrated strategies, and may be the most reliable path to reaching financial goals. Investors have more control over costs and taxes than over investment performance, and high costs and high turnover can create a high hurdle to clear for investment success. Investing in lower-cost and tax-aware index investments, factor-based investments or actively-managed investments may be a more reliable path to success than an approach that attempts to identify “genius” managers that will outperform the market.
[See: 13 Ways to Take the Emotions Out of Investing.]
Follow a systematic investment approach. Emotions can be the enemy of investment success. Few, if any, professional investors have been successful market timers; for individual investors a market-timing strategy is even less likely to be successful. A strategy that incorporates regular investments, periodic rebalancing to target weights and avoiding emotionally driven decision-making is more likely to succeed.
Investments in securities are not insured, protected or guaranteed and may result in loss of income and/or principal. This communication may include opinions and forward-looking statements. All statements other than statements of historical fact are opinions and/or forward-looking statements (including words such as believe, estimate, anticipate, may, will, should and expect). Although TFC Financial Management believes that the beliefs and expectations reflected in such forward-looking statements are reasonable, it can give no assurance that such beliefs and expectations will prove to be correct.
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Investing in the Age of High Frequency Trading and Lower Expected Returns originally appeared on usnews.com
