By Eleanor Bloxham, CEO, The Value Alliance

What do trading and market structure have to do with investing? That’s a good question, because the answer may not be that obvious. The Greek debt crisis and the future of market regulations are all occupying the current headlines. So, too, is the tumble that the markets experienced on May 6 and subsequent days.

As all investors recognize, the stock market over the last dozen years has been changing. There’s more volume and more long term volatility.

In the past, it was pretty simple for investors to apply the idea that, if you buy a basket of securities with a variety in it, you will dampen your risk and are likely to improve your risk adjusted return over the long haul. And for the most part, you could count on the idea that the stock market would always have an upward slope – at least over the long term. Because the market itself was dependable over the long term, non-diversifiable risk (also referred to as systemic or market risk i.e. risk associated with the stock market itself) was not much of an issue or concern. As a result, issues of risk in portfolio management were less of an issue than they are today: non-diversifiable risk or systemic risk wasn’t a factor over the long term and diversifiable (or specific) risk wasn’t a big issue because it could be diversified away.

Diversification And Risk

Today, diversification must be much broader across geographies and asset classes. In addition, one has to pay even greater attention to the risks embedded in specific asset classes, sectors and investments because of the possibility that a small risk in one place will be magnified elsewhere.

The “risk of an asset price collapse remains the strongest risk on the landscape on the severity and likelihood axes” according to the 2010 Global Risks Report of the World Economic Forum. http://www.weforum.org/pdf/globalrisk/globalrisks2010.pdf

Trust in the capital markets and the regulatory regimes that promote that trust, are, therefore, important issues for investors today, as never before. Currently there are a number of issues impacting the capital markets, their structures and function, which investors need to understand.

• High frequency trading. This is an issue much in the news, especially with the downward spiral of May 6 and, for the past few months, it has been an issue under review at the U.S. SEC. The question for investors is – do the markets really need millisecond liquidity? From an investor perspective, what is being given up in terms of trust in the markets by this phenomenon, particularly related to long term holdings, the ones investors value and should be seeking to protect?

Even those who use high frequency trading believe the potential danger is great: “Andrew M. Brooks, head of United States equity trading at T. Rowe Price, a mutual fund and investment company that often competes with and uses high-frequency techniques” states “we’re moving toward a two-tiered marketplace of the high-frequency arbitrage guys, and everyone else. People want to know they have a legitimate shot at getting a fair deal. Otherwise, the markets lose their integrity.”(Stock Traders Find Speed Pays, in Milliseconds, Charles Duhigg, New York Times, July 23, 2009)

• Market volatility with diminished upside. The market has been a volatile roller coaster over the last ten years. The S&P 500 closed at 1115.1 at the end of December 2009, which is still below the 1229.23 close at the end of 1998, eleven years earlier (although it is up from the end of 1997). On May 6, it closed at 1128.15, and as I write this, it seems to be headed lower. Stocks are no longer the relatively safe and steady investment they once were. This definitely impacts trust and the desire of other investors to be invested in stocks. Market demand impacts market pricing.
• Asset class shifting. What are the big players doing? “Companies are quietly and gradually moving their pension funds out of stocks. They want to reduce their investment risk and are buying more long-term bonds.”… “public pension funds are trying a wide range of investments: commodity futures, junk bonds, foreign stocks, deeply discounted mortgage-backed securities and margin investing. And some states that previously shunned hedge funds are trying them now.” (Public Pension Funds Are Adding Risk to Raise Returns, Mary Williams Walsh, New York Times, March 8, 2010) Tax policy changes, of course, also cause asset class shifting.
• Globalization. As other countries prosper, the pool of dollars to invest in the U.S. has grown. At the same time, more U.S. dollars are flowing overseas. The markets of choice and levels of trust in those markets are changing over time and watching these larger movements can be instructive.
• Impacts of governmental stance on corporate governance. A study undertaken by Pace University and Alliance Bernstein has shown that “the stance on corporate governance and equity culture and the political, social, and environmental climate of the country are both positively and significantly related to firm-level governance” and “firms located in countries with high country-level governance ratings did in fact predict significantly better future risk-adjusted stock return performance”. (Corporate Governance Ratings in Emerging Markets: Implications for Market Valuation, Internal Firm-Performance, Dividend Payouts and Policy, Aron Gottesman, Matthew Morey, Edward Baker, Ben Godridge, April 6, 2007) Thus, regulations which ensure high standards of governance in a country seem to be positively correlated with better market valuations and better returns, a rising tide lifting all boats.

Final Thought

As investors, it is important to understand these issues in making portfolio decisions and in expectations for future risks and returns. Investing isn’t as simple as it used to be. Paying attention to these issues can help you structure your response.

(Copyright 2010. The Value Alliance Company. All rights reserved).

Eleanor Bloxham is CEO of The Value Alliance (www.thevaluealliance.com), an educational and advisory firm. She is an author of books including Economic Value Management in the Wiley Finance series, as well as many published articles and videos. She has appeared on CNBC, CNN, Fox Business, and Bloomberg TV and in major newspapers in the US and abroad sharing her analyses of companies, trends and public policy.