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New York City: Where Volatility Never Sleeps

I was recently in Brooklyn, New York to attend a NAPFA-sponsored investment conference along with several hundred of my fellow independent advisors and financial planners. I was also able to catch up with the six colleagues in my Mix group (as introduced in previous blogs). At both the conference and within my smaller mix, there seemed to be a dominant theme on most of our minds:

How can we help investors cope with the current levels of market volatility?

New York City seemed the perfect place to tackle such a question. It is home for approximately 8 million people and is among the most ethnically diverse populations you might find. Somewhere around 43,000 police officers serve to keep the peace for the full time residents, thousands of tourists, and the current Occupy Wall Street movement. The New York Stock Exchange (NYSE) also finds its home there, which is just a short walk to the site of the 9/11 attack and memorial. If ever there were a city that embodied volatility, it would have to be NYC. Did I mention the harrowing cab ride from the airport to the hotel, or the subway that derailed during my stay?

Touring the Exchange: The More Things Change…

While there, I was able to arrange a private tour of the NYSE through our custodian Charles Schwab & Co. A Managing Director of the NYSE guided the tour, explaining how there used to be thousands of floor traders shouting orders from various pits in a system of organized chaos. These days, the heyday of open outcry has been largely replaced by worldwide electronic trading. During my tour, I saw handfuls of individuals, huddled around small, computer-filled booths. There was definitely energy present, but there was an overall appearance of order and civility.

In this respect, maybe times have changed. But even if the trading activities seemed more sedate, the daily numbers in the business section of The Wall Street Journal tell a different story. I asked our guide about the issue of increased volatility. Did he think it was due to high-frequency trading, heightened global uncertainty, or something else? His take was that it was likely due to a combination of more market participants from around the world, along with better technology enabling most orders to be transacted by computers rather than individual traders.

“Is that a bad thing?” I asked. “I mean, are the computers in charge now?” He replied that the efficient, more global exchanges made possible by electronic trading actually help provide more market liquidity. There are more players, with more opportunities in our capital markets, and that can be a plus. And of course, ultimately, computers are only acting on human commands. But the flip side of the higher activity may be higher ongoing volatility.

Back at the Conference: The More They Stay the Same

So what does all this mean for us as long term investors? While it was interesting to tour the exchange floor, back at the NAPFA conference, the subject of managing market volatility remained top of mind among presenters and attendees alike.

Most of the strategies discussed were really nothing new. Listed options, short-selling, and “black swan” funds (purchasing funds that are expected to run contrary to the primary direction of the market) were among them. There were also a few newer variations on the same themes, such as investing in the volatility itself by purchasing Exchange Traded Notes (ETNs) that buy and sell volatility. That way, in theory, you’ve hedged a bet that rewards you when markets plunge.

The same problems with all of these strategies are two-fold: the cost and the innate unpredictability of the near-term future. Mostly, it’s the cost. Some of the ETNs actually drain an investment at a rate of 10 percent per month! Imagine how much the ETN must outperform the sensible, low-cost asset class funds we use, simply to break even after the brokers get their cut.

Which returns us to the fact that the future is unknowable. Unless there is a “lucky” catastrophic event within the very narrow timeframe in which the ETN is held (enabling you to reap high returns on your bet), the holding only serves as a significant drag on your portfolio’s overall returns. Generally speaking, these instruments are designed for speculating on short-term outcomes, rather than preserving your lifetime of personal savings.

Lessons To Bring Home: Planning and Discipline

Besides getting to network with my Mix colleagues, the conference was useful because it further substantiated the wisdom in our existing strategies. Even during heightened volatility, long-term investors can still take sensible steps without trying to time the market, speculate on short-term outcomes, or make expensive, nonsensical predictions that may or may not play out. Instead, continue to manage for volatility by building a low-cost, broadly diversified portfolio, containing asset classes from around the world, and pro-actively rebalance among them to stay on target with your personal goals.

After that, you must tolerate the daily chaos in exchange for long-term vitality. Do as New Yorkers do in their city that never sleeps. Go with it. Better yet, ignore it. Focus on the things you can control and that are relevant to you personally. Tune out the rest of the madness.

By the way, the cheesecake was awesome!