8 ways to cope with stock market uncertainty
September 04, 2013
A three-hour shutdown of the Nasdaq stock exchange on August 22 renewed concerns about the dependence of financial markets on computer technology. Between systems glitches and volatility stoked by automated trading programs, technology has introduced a new element of risk into financial markets.
Like other forms of investment risk though, exposure to flaws in the trading system can be managed through a fundamentally sound approach to investing. Here are eight ways you can reduce your exposure to various market uncertainties.
1. Focus on long-term value
People with high-turnover trading strategies depend on instant access to the market at all times, but if you are buying companies because of their long-term fundamentals, you can generally afford to sit back and wait till short-term trading disruptions sort themselves out.
2. Understand what you invest in
The combination of technology and derivative investments has given rise to some highly technical trading strategies that try to take advantage of temporary anomalies in market prices. The problem is that the complexity of these strategies can make it difficult for investors to truly understand what bets they are making and what risks they are incurring. Don't invest in anything unless you can game out the full range of possible outcomes, and always know how to limit your exposure.
3. Beware of the autopilot
Automated trading programs have made mistakes that have cost investors millions, and sometimes have thrown whole markets into turmoil. Investing should be a series of purposeful, well-thought-out actions, not simply numbers generated by a computer program. Use technology to implement your investment decisions -- not to make those decisions for you.
4. Be price-conscious
In most cases, trading glitches have a temporary impact, but the risk is that they can effectively reset the price level of overvalued stocks by breaking their momentum. The more you focus on buying stocks at prices that represent a reasonable discount to future earnings, the less you will be dependent on momentum for your returns. Pricing may be especially tricky in today's market, with low bond yields and savings account rates having pushed stocks to levels that may be tough to sustain if interest rates rise.
5. Pay attention to liquidity
Thinly traded issues are most vulnerable to price distortions due to trading anomalies, so make liquidity a factor in anything you buy.
6. Diversify purposefully
Spread your investments around, but do so with a targeted asset allocation in mind. This should be a function of your long-term goals and current market conditions, including price levels, economic growth, bond yields and savings account interest rates.
7. Keep good records
Make sure you keep your own set of records for investment holdings and bank accounts, so if there is some kind of a system problem, you have documentation of what you own.
8. Value credibility
Nasdaq's credibility has taken a hit because of trading glitches, and the onus is on them to demonstrate that they have addressed the problem effectively. Credibility should be a factor in which exchanges you trade on, which companies you buy, and which investment firms you trust with your money.
Ultimately, problems in the trading system are a bigger problem for traders than true investors. The more you invest to own something of intrinsic value rather than to turn a quick trading profit, the less vulnerable you will be to trading disruptions.