Risk, Lions, and High Frequency Trading

Professional investors distinguish between two types of risk when investing their clients’ money.

Unsystematic risk (also called “company-specific risk”) is specific to owning an individual security. This type of risk can be greatly reduced by owning a well-diversified portfolio. Portfolio managers seek to construct portfolios with enough securities so that any one company-specific event does not result in disaster for the portfolio as a whole. Estimates vary on the number of securities required to minimize unsystematic risk, but you’re likely to see figures ranging from as little as twelve to as many as thirty or more. It is important to note that because unsystematic risk can be diversified away, investors are not paid for this risk. In other words, if your portfolio is not diversified, you are taking on unnecessary risk.

Systematic risk (or “market risk”), on the other hand, is risk that cannot be diversified away. It is risk that affects the entire market and not just an individual stock or industry. According to Investopedia.com, systemic risk is also unpredictable and impossible to completely avoid. If you have been an investor over the past few years, you will probably agree that the lion’s share of the volatility in stock prices has been the result of systematic risk rather than unsystematic risk. First, the financial crisis and recession caused a massive sell-off in stocks from which very few companies were immune. Then, the response from the Federal Reserve and federal government in the form of fiscal and monetary stimulus has served as a “rising tide that lifts all boats.”

From time to time you will hear professional investors on TV say that in the future we are more likely to have a “stock picker’s market.” This simply means that stock prices are less likely to move in unison based on macro events and more likely to move in response to company-specific developments. Obviously this is the type of environment most investors should covet. As we’ve noted many times in the past, the Fed should neither be opining on nor manipulating stock market valuations. Unfortunately, it seems we are still some time away from getting back to a more “normal” environment. The Fed seems intent on driving stock prices higher as a means to prime the economic pump.

To emphasize the point that systematic risk is largely unpredictable, John Mauldin uses the analogy of lions stalking invisibly in the tall golden grasses of Africa. You know they’re there even when you can’t see them, and you know that they will at some moment burst forward and pounce. Mauldin points out that investors are ever on the lookout for lions, but he suggests that they often miss the unforeseen collateral consequences of the pounce. Sometimes a stampede ensues. Stampedes can cause dust storms, or trample villages, or… you get the idea.

Vigilance for lions and their consequences is a part of any professional investor’s daily routine. Many hedge funds and other short-term investors believe they have an edge in foreseeing systematic risk, or near-term events that will move markets in one direction or another. Others will claim they are better able to identify company-specific, or unsystematic risk. Either way, these event-driven, short-term traders believe they have a better mouse trap. Smart people will disagree as to whether anyone can produce consistent outperformance through short-term trading such as this. It largely depends on whether you believe in the Efficient Markets Hypothesis, which states that stock prices already reflect all relevant, publicly-available information. But how do we do we define relevant, publicly available information?

High Frequency Trading (HFT) is the subject of a new book by Michael Lewis and of many media discussions. It has been around for a while and is the primary culprit behind the “flash crash” of 2011 when the Dow fell 1,000 points in less than an hour. This trading is generated by computers that buy and sell hundreds of thousands of shares in milliseconds (much faster than the blink of an eye). They portend to operate on mathematical algorithms that calculate every trade in certain securities and place buy or sell orders when the algorithm detects anomalies. The profits on these trades may be in pennies per share, but they are based on a LOT of shares.

Lewis suggests that there is something more sinister afoot. He suggests that the HFT’s have an unfair advantage in that they are seeing orders before they even hit all the exchanges. You can imagine the advantage of buying or selling just before someone else did. It’s a fixed game, and if it’s not illegal, it probably should be. The term of art is “front-running.” Front-running refers to the placing of trades prior to the dissemination of material information. Needless to say, the Securities and Exchange Commission and the Justice Department are looking into these allegations. For purposes of our discussion, it is noteworthy that some HFT’s have found a way to avoid (at least some) systemic risk. Unfortunately, the HFTs’ gain is everyone else’s loss. If we cannot depend on the integrity of the markets, isn’t this just another systemic risk? Doesn’t seem fair, does it?

At present, caution is warranted. Those who have known and read us for years know that we are always fairly cautious. Markets are wonderful at providing new reasons for concern. Maintaining a focus on companies with defensive revenue streams and conservative balance sheets makes most sense to us. As we foresee only modest prospects for economic growth in the US, we favor those companies able to access growing areas around the world. International operations across different economies and currencies offer greater diversification, higher growth rates and some protection from inflation.

Peace,

Michael