What to do About Market Volatility

Investors are upset by the recent big increase in the number of wild days in the stock market. After any volatile period, some investors react emotionally-and they suffer real harm. Some investors settle for safe investments that offer rates of return so low that they will have a hard time achieving their goals, while other investors become spooked and sell at the bottom. What can we do to avoid the high costs of this excessive volatility?

BWFA can help investors alleviate a portion of these choppy waters by selecting an appropriate investment model designed for the investors’ needs. BWFA can’t control the market’s volatility, but we can help them keep on track by making the day-to-day decisions that avoid costly strategic mistakes.

However, many economists and market experts think there are steps we can take that would reduce market swings. BWFA supports efforts to find better ways to run our financial markets that allow investors to earn good rates of return while sleeping at night. However, we must be careful to avoid regulations that interfere with necessary parts of an efficient, free-market system, and thus cripple the goose that lays the golden eggs.

Let’s take a look at some of the proposals floating around Washington, DC, these days to reduce market volatility.

· Limit “blackbox” high-frequency computer trading

—Computer trading systems using complex algorithms were heavily involved in the infamous “Flash Crash” on May 6, 2010, when the Dow Jones Industrial Average dropped 900 points in less than 30 minutes. Computer trading does push the stock market around, sometimes in damaging ways. Yet, these firms provide a valuable service to all buyers and sellers of stocks by providing liquidity. In other words, they buy whenever we want to sell, so we can always sell stocks quickly.

· Limit short selling

—Short selling is selling a stock now with the hope of buying it later at a lower price. Thus, the investor makes money when a stock goes down in value. Many experts claim short selling can push down stock prices further than necessary, thus increasing volatility on the downside. It’s probably true, but short-sellers provide crucial discipline on stocks, too. In addition, why should we restrict an investor’s profit if that investor believes that a stock or the stock market is overvalued?

· Prohibit investment banks from trading for their own account

—Paul Volcker, chairman of the Federal Reserve from 1979 to 1987, is an advocate of limiting investment banks’ ability to trade for their own accounts. Investment banks provide market liquidity, and they help big companies raise money to build their businesses. However, the biggest investment banks, such as Goldman Sachs and JP Morgan Chase, make most of their money by buying and selling securities solely to make money. Since these big banks are in the middle of the action, they appear to have an advantage over regular investors and can make money whether the markets go up or down. They also make more money when the markets are more volatile, which gives them an incentive to cause excessive volatility.

· Impose a small fee on purchases and sales of stock

—A 5- cents-per-share charge on every stock transaction would be a big disincentive for rapid buying and selling. Unfortunately, even long-term investors would have to pay the fee as well.

· Prohibit leveraged and short-position Exchange Traded Funds (ETFs)

—Originally developed as inexpensive ways to match indexes, ETF managers have branched out into much more specialized investment strategies, including leveraging (borrowing) and taking short positions. These ETFs operate by borrowing money, so they can earn or lose two or three times the rate of return earned by the bundle of stocks they hold. Think of these as ETFs on steroids-and some experts argue that they can increase market volatility.


What Do We Think?

None of the ideas discussed above are close to being implemented today, but they will surely gain traction if the market continues to be very volatile. We don’t believe that any of the ideas would have a big impact on volatility, and they might produce unintended consequences that would create new problems. That’s why we at BWFA focus on what we can control: maintaining our clients’ portfolios for long-term, steady returns.