I love Michael Lewis’ writing, but I have some surprisingly good news to share about the high-frequency trading scandal revealed in his new book:
Yes, it is almost impressive that Wall Street has managed to produce yet another scandal, even under the ever more watchful eye of regulators and the media since the financial industry imploded in 2008.
And no, I don’t favor high-frequency trading or especially its less-sophisticated cousin, day trading. I thought former hedge fund manager James Altucher put it best when answering the question, “Should I day trade?”
“Only if you are also willing to take all of your money, rip it into tiny pieces, make cupcakes with one piece of money inside each cupcake and then eat all of the cupcakes.”
However, high-frequency trading, this scandal du jour, seems to actually push trading costs and bid/ask spreads (effectively, the net cost of purchasing a security) down for investors. High-frequency traders aren’t doing it out of the kindness of their heart, mind you, but it’s the large number of medium-frequency active managers who are losing out, not disciplined low-frequency investors. Wall Street’s movement toward high-frequency trading is only making a stronger case for passive asset class management—a major component of which is low-frequency trading.
The primary benefits of low-frequency trading are the reduction of trading costs, the minimization of taxable events and, especially, the avoidance of falling prey to what financial writer and artist Carl Richards calls “the behavior gap”—the difference between what the average investment returned and what the average investor earned. Sadly, investors have earned meaningfully less than the investments they buy simply because they don’t hold them.
I’m not talking about pure indexing, although you could do much worse than establishing a diversified portfolio with Vanguard index funds and/or exchange-traded funds.
I’m also not talking about pure white-knuckle passivity.
I’m talking about combining the art and science of investing in the form of evidence-based investing—creating a portfolio that is broadly diversified, combining the asset classes that have historically given you the most return for your risk with the asset classes that have tempered portfolio volatility enough to stick with your plan.
Evidence-Based Investing: 101
The fundamental aim of investing is not to actually make money--but to have a better life.
The primary objective of investing in stocks, however, is to make money. The point of investing in bonds, then, is to help you stay invested in stocks when the waters get choppy. The net effect should be adding value to your life, in accordance with your values and working toward your goals.
Evidence-based investing forces us to submit all of our opinions and informed guesses to actual peer-reviewed evidence. The evidence shows, after all, that it is nearly impossible to “beat the market.”
There is adequate evidence, however, that certain asset classes—slices of the market—have outperformed others. For example, you already know that stocks have historically outperformed bonds. Additionally, small-cap stocks have outperformed large-cap stocks and value stocks have historically outperformed growth stocks.
Of course, those asset classes that have historically produced outsized returns have also required an iron stomach at times in order to reap your reward. Their highs are higher, but their lows are also lower.
The objective, then, is to orchestrate a portfolio that accepts the risk you can withstand, and then blend that risk with the proper stabilizing agents to lessen the volatility, helping ensure that you stick with the plan.
Can You Expect More Return With Less Risk?
In short—yes, because a truly diversified portfolio is indeed greater than the sum of its parts . There are two ways to reduce overall portfolio volatility:
1) Own less volatile asset classes.
2) Own less correlated asset classes.
The foremost portfolio stabilizing agent is fixed income, and since the primary reason we hold fixed income is to stabilize, it only makes sense to hold the most stable of the stable—FDIC-insured CDs, Treasuries, agencies and, only if you’re in a high tax bracket, AAA-rated municipal bonds.
Yes, I omitted corporate bonds from that list as well as high-yield “junk” bonds, because these varietals tend to exhibit more equity-like risk characteristics. If you’re going to take risk, you may as well do it in an asset class that rewards you better—stocks.
But as Larry Swedroe, author of Think, Act, and Invest Like Warren Buffett, shows, it’s possible to add an equally or more volatile asset class and see the overall volatility go down .
He compares the traditional 60/40 portfolio—60% S&P 500 (stocks) and 40% five-year Treasury notes (fixed income)—to a flip-flopped portfolio with 60% in Treasuries, but a vastly more diversified 40% in equities, skewed in the small, value and international directions (and away from the broader market). The results?
In short, the 40/60 portfolio with diversified equity holdings outperformed the 60/40 portfolio with substantially less risk. (By the way, I’m not recommending that you should have a 40/60 portfolio—I’m simply demonstrating the benefits of thoughtful diversification.)
The only way this works is if you join the low-frequency trading club. Don’t set it and forget it. Set it, calibrate it when necessary through rebalancing, and only make more meaningful changes when your ability, willingness or need to take risk changes.
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