May 9, 2019
Episode 17: Q&A- High Frequency Trading & More!
Today we are going to answer some listener questions on a variety of topics. We will try to get to 2 or 3 questions on today’s show. I personally love the Q&A shows because we can get into a variety of topics like Social Security, taxes in retirement, investment planning, lifestyle questions, etc.
If you have a question, there are multiple ways to get them over to us to be answered on a future show.
Disclaimer: Please do not take advice from me on this show. As a licensed Fiduciary I am only allowed to give advice to clients. Unless you’re a client I can’t give you advice because I don’t know you. Think of this as helpful hints and education only! And please, before implementing any information or ideas you hear on this show always consult your legal adviser, your tax adviser, and your financial adviser.
(4:00) Practical Planning Segment:
Our first question is an audio question! This listener is a local right here in Maryland. What’s interesting about this audio question, which we will play in a second, is that we received a very similar question via email. (Play Audio Question)
“What is your opinion on how high frequency trading affects the efficient market frontier and the volatility of the markets?”
Now here’s the question we received via email from a Delaware resident:
(5:00) Why are computer trading algorithms so sensitive to the slightest positive or negative news item that they make the markets rise or fall dramatically in one single day? How does this affect portfolios?
These are both really good questions and I remember a few years back on a 60 minutes episode a gentleman by the name of Michael Lewis wrote a book called flash boys about the subject. It caused a lot of stir but he also got quite a bit of pushback on his conclusions.
Some argued that Lewis' book is more "fiction than fact," claiming Lewis never really understood HFT (High Frequency Trader) and the fact he never actually cited any interviews from an HFT trader. So, it appears it was written as one sided.
So, what the real story? Well lets first explain what it is and then examine if it’s something we should worry about.
(7:20) High-frequency trading or HFT is a program trading platform that uses powerful computers to transact a large number of orders in fractions of a second. It uses complex algorithms to analyze multiple markets and execute orders based on market conditions.
Article from May 2017 in seeking alpha from Konstantin Fedorov:
“Some are against HFTs, but there are also some who support them, saying that HFTs add liquidity and make the markets more efficient. It is a debatable topic, but both of them have their valid points.” Click here to read the full article!
Those who support HFTs have the following arguments:
1) Liquidity- it may be stated that HFT algorithms add a big share of liquidity to the markets mostly by passive market-making strategies. Market-making strategies minimize spread between buy and sell prices and also increase depth of the secondary market. In addition, big volumes cause transaction costs to decrease which is beneficial for all market participants.
2) Fair price valuation/volatility: Efficiency! HFTs require high volatility to earn their returns. From this perspective, they simply decrease deviation of an asset from its medium (or trend). This fact is very attractive for long-term investors because for them it lessens the risk of acquiring (or selling) an asset at a bad price. Efficiency of the markets increases with faster valuation and fairer prices caused by HFTs. Therefore, better price-making is certainly beneficial for capital markets and potential investors.
3) New techniques, new opportunities- A wide range of fundamentally different strategies came to the markets with HFT algorithms. Some people believe that such variety is providing flexibility and sustainability of the markets in general. HFTs can provide real-time response to market changes.
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(13:10) On the other hand, there are many people who disagree with the positive image of HFTs. In their view, HFTs cause uncertainty and can bring a catastrophe to the whole financial institution system. The most common claims are:
1) Flash Crash Risk- On 6th May of 2010, a major financial catastrophe occurred, also known as the Flash Crash. Popular American indexes collapsed for a couple of minutes. This event was caused mostly by HFTs, and therefore, created a negative public opinion towards them. Many people have realized since the Flash Crash that such extreme speeds can be dangerous for normal market functioning.
2) Market manipulations and fake liquidity- There is the practice of front-running large trading orders from institutional investors. HFTs can track big institutional orders. Then they usually try to absorb liquidity before big investors. The final step is to close HFTs' positions counter to big investors. The prices for institutional investors at the end are much higher.
3) Maintenance costs- HFTs' algorithms require a large amount of processing powers and all exchanges have to constantly update their equipment, cables and structure of working in order to be able to handle this increasing flow of HFTs' orders. At the end, it can increase costs for all market participants.
(18:00) My conclusion; it depends on what type of investor you are.
If you are a long-term investor that believes in market efficiency, establishing a risk/return target, and rebalancing back to your original target once maybe twice a year when needed, the net effect of HFT is positive. Why? Because it contributes to the efficiency of the market by providing liquidity and driving transactions cost down.
If you are a day trader or stock picker (which by the way is not investing), you may find yourself on the wrong side of the trade and because you are not a long-term investor, you’re a gambler.
Please don’t kid yourself that you are investing your money if you are trading individual stocks. There’s is a huge difference between investing and stock picking. People that stock pick are speculating and gambling……not investing!
I cannot emphasize this enough. And can you tell, I feel very strongly about it.
(20:30) Next question…
Is there a formula for withdrawals from your accounts in retirement? A formula for determining how much one can remove per year and not blow it all?
There are all sorts of formulas and strategies for withdrawing your retirement funds, but I think the most popular one most people have probably heard about is the 4% rule. We’ll get into that rule or (guideline) in a little bit but first let’s talk about the factors that could affect the frequency and amount of withdraws.
Lifestyle; the way you live and the lifestyle you want to maintain. Here we talk about 2 things: #1 is our basic needs requirements. (I’ve heard it described as a minimum dignity floor). What do we need to meet and live at a minimum dignity level, food, shelter, healthcare?
#2 Dreams/Wishlist; This is where we really “live”! This is what we retired for! Not all retirement years are going to be the same. I often talk about and you’ll hear that retirement could last 30 years. From my experience working with retirees…. not all 30 years are the same. The first 10 to 15 years are described as the go-go years……… next decade is the slow-go years……………and the 3rd decade is the wont-go years.
Health/Longevity; how healthy are you and do you have a history of longevity. None of us know exactly when that day will come but from a health and family history standpoint can provide some clues. Females on average live longer than men aby about 5 years. So, looking at a withdraw rate with the understanding ladies tend to live longer is another factor that should be factored into to any plan. Retirement plans are much more important for women in my opinion. Many men that never bother to create a plan will never find out that it didn’t work. Of course, when talking about health you cannot dismiss healthcare costs later in life especially regarding any type of LTC. A LTC event can drastically accelerate your withdraws.
Risk tolerance; risk tolerance cannot be underestimated here. Risk is a doubled edged sword. I think we all know with risk come return……….no free lunch. There is no such thing as a “safe” investment where you can earn high returns with no risk. It just doesn’t exist….no matter what that junk email or fraudulent phone call you receive with someone promising high returns unrelated to risk.
You know the email we all have gotten saying a Nigerian Prince has just left us 3 million….now that’s pretty obvious but I have seen others that promise high double digit return if just follow what’s in the newsletter…by the way the newsletter cost $2500/yr! So what are they really selling!?!?
So our options are to take zero risk or lets say little risk………..like an FDIC insured bank account . So, we are giving up growth of our assets. We might get a little growth but typically we are lagging inflation. So, our real return especially after taxes can be negative when we subtract inflation and taxes. If we are withdrawing to “Live our lifestyle” you will see the account balance deplete over time
On the other end of the scale is 100% equities or stocks. Let’s further say at the extreme end is having all your money in one stock. Now that crazy right? That’s speculating and gambling. high risk……. lose it all like WorldCom, Enron, lucent….etc. Of course, it could also go up astronomically. That’s a gamble that most folks do not want to take in retirement.
So, a better way is to develop an investment and income plan.
(26:00) Side note on identifying risk tolerance; from my experience a client’s risk tolerance can change by the day or even worse by the minute. When markets are volatile people emotions, perceptions, and instincts often get in the way and they can make harmful portfolio decisions in a split second!!!
This is why I think an investment advisor that is a true fiduciary and a “coach” really adds value! I consider it my job to coach and try my hardest to make sure a client’s emotions, instincts, and perception of what’s going on don’t get in the way of their overall goal.
Now, I’m not always successful……. a recent client comes to mind that felt uneasy about the last quarter of 2018. Even though we had a long term view of 6 to 9 years and designed a portfolio to meet those expectations………..sometimes those emotions take over to such an extreme level and in a split second they cash out a portfolio……instead of following a rebalancing approach and staying disciplined for life. That decision cost them a signicant return in this 1st quarter of 2019
US equities measured by the s&p are up 13%, international is up roughly 10% in the 1st quarter.
(31:00) Other income sources; The final factor (I’m sure there are others to consider as well) are your other income sources and whether or not they are “guaranteed.” I.e. pensions and social security. These two cannot be underestimated as part of your over withdraw strategy and income plan.
These may be the bedrock of your plan and may possibly be the income sources that meet that minimum dignity floor we mentioned earlier. I won’t get into the health of SS because we have talked about that on past shows. I will say, the latest report from the trustees showed an improvement in the SS system. Especially the disability part.
Now back to the listeners question, and is there a formula for w/ds?
Well I think after that going over all those factors you can begin to see that there really is no “one size fits all” formula because every one of those factors will be different for each person.
Now you will hear about certain formulas like the 4% rule. That rule or should be better stated as a guideline not a rule. It states that a retiree invested in a balanced portfolio mix…. like 50/50 or 60 /40 bonds may w/d 4% per year and have the account last approximately 33 years
This rule seeks to provide a steady income stream to the retiree while also maintaining an account balance that keeps income flowing through retirement. The 4% rule was created using historical data on stock and bond returns over the 50-year period from 1926 to 1976.
Before the early 1990s, experts generally considered 5% to be a safe amount for retirees to withdraw each year. Skeptical of whether this amount was sufficient, financial advisor William Bengen conducted an exhaustive study of historical returns in 1994, focusing heavily on the severe market downturns of the 1930s and early 1970s. Bengen concluded that, even during untenable markets, no historical case existed in which a four percent annual withdrawal exhausted a retirement portfolio in less than 33 years.
The original rule also accounted for inflation……stating that you could increase those withdraws each year
Article on the 4% rule: https://www.kitces.com/blog/how-has-the-4-rule-held-up-since-the-tech-bubble-and-the-2008-financial-crisis/
Final Disclaimer:
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