Another instalment in a series of articles detailing how to design a secure, income-producing portfolio
When there is a market disruption, whether it’s a major crisis or a garden-variety fluctuation, there is more instability in stock markets today than in years past. There are several reasons for this. One is that market participants with similar portfolios are likely to respond to the same event in the same way and today’s market is full of copycat portfolios. For now, suffice to say that when everyone holds more or less the same mix of stocks, and responds to a market correction in more or less the same way, it exacerbates price swings.
Another cause of worsening volatility in our modern world is that fact that, increasingly, many market participants are not human at all. That is to say, many of the entities issuing buy/sell orders are not people, but computer algorithms. These algorithms are essentially pattern-recognition machines. In the simplest terms, they are developing and following instructions like when event X occurs, take action Y. These machines may act in tandem with human traders, but they also may act in ways that are far more damaging. If powerful computers discern that selling the market and helping to precipitate a downdraft will create opportunity – because they will be able to sell high and then buy low – there is nothing to stop them from doing just that. Thus computer trading can make volatility, and downswings, far worse than they would be otherwise. To a large degree, recent stock market volatility, which has reached once in a lifetime scale, is the natural outcome of indiscriminate algorithmic trading.
“Today the way we’re consuming news is kind of like putting our mouths up to a fire hydrant”
Another reason volatility is increasing is to do with the way we receive news about geopolitical events and how much such news we receive. As a society, we used to gather information from just a handful of sources, with stories arriving at a low frequency and on a predictable basis. Today the way we’re consuming news is kind of like putting our mouths up to a fire hydrant. We’re living with deep unease about geopolitics while our phones deliver a constant stream of updates, a great deal of which is speculative, while people on TV are yelling money, money, money. The information flow from local, national and global events now exceeds any single human’s ability to comprehend and follow, and this raises the potential of negative surprises, as some fact that has been hiding in plain sight suddenly becomes the focus of the news media and the market. We try to digest everything we hear, but most of us end up with information overload. And what’s the result of that overload? Complacency. Not because we don’t care, but because we throw up our hands in bewilderment: when you focus on everything, you focus on nothing. We end up tuning out. We tune out, that is, right up until something comes along that’s big enough to puncture our complacency and suddenly we’re afraid. Many investors toggle between complacency and fear, and the transition between those emotional states is happening more quickly now than before.
People buy and sell liquid securities with the expectation that the market will accommodate their needs and desires. One person may sell TSLA and buy Apple. Others are selling Treasuries. Some people are buying municipal bonds. The diversity is key, because if all investors wanted the same thing, there would be no market as we know it. Long-term investors accommodate the needs of short-term traders and vice versa. But when a feedback loop forms, in which a fearful impulse spreads, previously diverse populations of participants begin to react the same way. In a crisis, or even an ordinary bear market, as fearful reactions create more fear and therefore more reactions, correlations begin to go to one. That is, the correlation between the change in value of your portfolio, and the change in value of the entire market, collapses to one. The market’s loss is your loss. There is no place to hide.
“Everyone’s portfolio is ‘diverse’ in the same way”
The reason this happens is simple. In times of stress, everyone goes to the same place: the exit. It doesn’t matter what sort of liquid security you’re holding, because the room only has one door. You sell and pull out your cash. When there’s panic, even stocks and bonds correlate and change in lockstep. Maybe your broker said that would never happen; maybe you thought your portfolio was constructed to be counter-correlated – to be diverse and therefore protected. But everyone else had that same strategy, too; everyone’s portfolio is ‘diverse’ in the same way. Everyone experiences the same stress at the same time. The herd moves quickly and synchronously from complacency to fear. Everyone wants out at the very same moment and no one can keep their hand off the sell button.
But if you don’t need the cash, why are you selling?
If you’re seeking high returns with low risk, then the unpleasant truth is that you’re going to have to be more creative than simply investing in liquid securities like everyone else. This might sound like heresy, but it’s really just standard finance. If debt offers the same return as equity, but with lower risk, then go with debt. If there’s an opportunity in liquids, you should take it; when I had the chance to buy Amazon around 11 bucks in the summer of 2001, I did, and you can be sure I didn’t regret it, regardless of its liquidity. But liquid markets are the opposite of oversold and washed out as they were back then.
