High-frequency computerized stock trading dominates more than 70 percent of all stock market volume today and is disadvantageous for us "little guys." Rapid trading distorts market pricing when our favorite mutual funds decide to buy or sell a major position in a stock. They are forced to buy higher and sell lower than would otherwise have been the case five or 10 years ago.
The fact that this trading phenomenon can also bring markets to their knees with a "flash crash" is almost beside the point, considering that the first problem amounts to death by a thousand cuts on a daily basis.
Meanwhile, we have yet another problem caused by these new market wizards. According to Richard C. Young's Intelligence Report, there was quite a bit of inverse correlation between different investment styles up until 10 years ago. This meant that when one type of mutual fund was up, another could be down. "Correlation," by comparison, describes the situation where two types of funds usually move in the same direction. Today, the amount of correlation is three times higher than it was in 2000.
Combining two opposing (inversely correlated) funds reduced risk by creating a composite result that looked more like a straight upward line. This straight line of results -- the path of minimum regret -- created the basis for what became known as modern portfolio theory: an investment methodology that reduced risk while maintaining the possibility of higher overall returns.
Here's an example, but first some background: Mutual funds investing in small, solid companies with little debt are categorized as "small cap value funds." Funds investing in large companies that are borrowing heavily and reinvesting any profits in new people, space and capital equipment are known as "large cap growth funds."
In 1999, large cap growth funds gained 60 percent in that year alone. Small cap value funds earned zero. The following year, in 2000, small cap value funds gained 30 percent and large cap growth lost 30 percent -- a 60 percent flip-flop between the two styles from one year to the next. Perhaps it was one of the purest expressions of "inverse correlation."
Now, because of high-frequency trading dominates the market, all investments styles are much more greatly correlated, and this means less diversification for those of us trying to reduce risk by allocating our money across a mix of fund types. The rise of exchange-traded funds (ETF) that can be used in high-frequency trading has been the root cause of the reduction of diversification. These funds typically invest in index funds of varying types, so a rising ETF price reflects rising demand for all the stocks in that ETF across the board, and they all rise together.
It also means that rebalancing doesn't generate as much of a potential incremental increase in annual gains as it once did. Rebalancing is the practice of taking a few percentage points from a winner and adding them to a loser -- effectively buying low and selling high on a mechanical basis rather than struggling to second guess what the market was going to do next.
Rebalancing has the advantage of adding as much as a half percent to average annual returns over long periods of time, but with all types of investment styles now moving together to a greater extent, the differences are not as significant as they once were. We're now buying "just a little higher" and selling "just a little lower" than we used to when rebalancing portfolios.
It is tempting, therefore, to go further afield than just the U.S. stock market to further diversify. Emerging markets, China, Europe, select industry funds and even bond funds may offer what we need in an effort to diversify and reduce risk. What's annoying is that we have to rethink a time-tested strategy because a relatively small number of investors appear to have fouled the nest.