Investing Involves Risk

If you consume finance-related media or read about investment products, you will be familiar with these disclosures:  

“Investing involves risk.” 

“Investing involves risk of loss.” 

“Investments are subject to market fluctuations.” 

The prices of stocks and the many financial products derived from them are volatile. The degree to which stock prices move on any given day varies, but the prices are nearly always in motion. This volatility creates opportunities for investors as it is one of the primary reasons why long-term rates of return for stock-related investments are high – to compensate for the risk inherent in holding these types of assets. While benefiting investors, volatility can also be problematic. It creates anxiety and causes investors to lose money if they sell stocks when the prices are down. Volatility and risk are an unavoidable part of investing in stocks, and we will continue to address these issues in many investment- and retirement-related articles. 

While price movements may be unpleasant for investors, most stock price movements are healthy and are the expected result of a functioning market. However, on rare occasions, short-term price movements of stocks fall outside the range or type of movements expected in a healthy, functioning, rational market. On June 3, 2024, just such a price movement occurred in several individual stocks, triggering market safeguards that temporarily halted trading in shares of the impacted companies. In this week’s post, we would like to explore with you what these safeguards are in the United States and how they contribute to maintaining an orderly, functioning market. We would also like to share the strategies that we use to protect our clients from these types of exceptional short-term price movements.  

Stock Prices: The Origin Story

The value of individual companies, which in turn impacts the value of stock markets in general, is fundamentally based on two components: (1) the future cash flows those companies are expected to generate and (2) the price investors are willing to pay today in exchange for a portion of those future cash flows. We live in a dynamic and well-connected world that is in constant flux. Factors ranging from legislation to current events to investor sentiment are continually impacting each of the main factors that determine stock prices. The U.S. public capital markets are designed to allow investors to respond instantaneously to new information as it becomes available. Investors digest new information, which impacts prices, and those prices are in turn instantaneously published and made accessible to investors. It is a transparent feedback loop that ensures markets behave rationally, that prices reflect all currently available information, and that investors can see those prices and use them to assess investment decisions.  

This does not occur by accident. An enormous infrastructure underlies this system and allows it to work. This infrastructure was created by and operates with the help of market participants and contributors, including exchanges, regulators, data providers, and news outlets. It is a system that enables and permits the free flow of information and the free functioning of market-based pricing through a resilient, interconnected network. Billions of shares worth hundreds of billions of dollars are traded daily on American exchanges at fair prices and with extremely fast execution.  

The Needles in the Haystack

On exceedingly rare occasions, events occur that disrupt the orderly functioning of equity markets. The causes of these disruptions may involve technical glitches within the market’s trading infrastructure, errors in the execution of trades by market participants, or incongruity – whether real or perceived – between available information and market prices.  As rare as these events are on a wide scale, considering the volume of capital moving through investment markets they come with high potential costs for market participants. Due to the risks involved to participants and to overall confidence in the markets, various stakeholders have worked together to put in place safeguards to halt trading when market movements signify a possible temporary break in the orderly functioning of the broader market infrastructure. 

The first market-wide safeguards came about after the Black Monday stock market crash of October 19, 1987, during which the U.S. stock markets – as measured by the Dow Jones Industrial Average (DJIA) and S&P 500 indices – fell by over 20% in a single day. Several factors impacted this “flash crash” in prices, including the use of relatively new computerized trading programs and portfolio insurance strategies. As markets declined that day, sell orders were generated consistent with the rules of these strategies. These sell orders prompted further market declines, which in turn prompted even more sell orders to be generated. Very quickly a negative feedback loop developed wherein selling begot more selling. Critically, the pace of market movements soon led to valuations that bore little direct connection to the fundamental pricing of investments based on the current value of expected future cash flows. The resulting market decline was extraordinary. Black Monday remains the biggest one-day percentage drop in U.S. stock market history. 

Following the Black Monday crash, circuit breakers were put in place to halt trading under specified market conditions to prevent history from repeating itself. Trading halts allow time for exchanges and other market participants to determine the cause of extraordinary market movements. The pause in trading is one way to arrest a price spiral that leads to a disconnect between share prices and market fundamentals, such as the one that occurred on Black Monday. The original regulations put in place after the 1987 crash were updated in 2012 and placed in force in 2013. The current mechanisms encompass rules designed to minimize disruptions in the trading of individual stocks and in the functioning of broader stock markets. 

Safeguards of Today

Extraordinary volatility in the share price of an individual stock is regulated by the Limit Up-Limit Down (LULD) mechanism put in force in 2013 to replace a prior rule that had originated in 1988. The LULD mechanism halts trading in a security when volatility significantly exceeds price movements that would ordinarily be considered normal based on the dollar value of the stock and the time of day, as greater volatility is often experienced shortly before the market closes. As the name implies, LULD rules may kick in due to a price decline or a price rise.  

In addition to the LULD mechanism, other functions are in place to halt trading in individual stocks when necessary to ensure the equities market’s orderly functioning. These halts can occur for several reasons, ranging from noncompliance with exchange requirements to pending dissemination of information material to the stock price. 

There are thousands of publicly traded companies in the United States, and on any given day there will often be some that are impacted by these individual stock trading mechanisms. Most impacted stocks are of small companies with no impact on the broader market or on most market participants. As this article is being finalized on June 10, 2024, there are more than 10 trade halts in place on publicly traded securities in U.S. markets. Most of these deal with material information issues concerning relatively small companies.  

Recently, on June 3, 2024, a technical issue involving published LULD data caused trading halts on about 40 individual stocks, including some large companies such as Berkshire Hathaway. The Consolidated Tape Association – a market data organization used by major exchanges to jointly provide real-time stock quotes – published erroneous information that led to the halts and subsequent price movements that did not correspond to market fundamentals. The halts did not appear to have a notable effect on the value of the major market averages. Trades made at erroneous prices due to the glitch are being reviewed and reversed by the exchanges.  

Existing in parallel to the mechanisms preventing undue volatility in single stocks are market-wide circuit breakers that halt trading completely across exchanges in the event of an extraordinary single-day decline in the value of the S&P 500 index. Unlike the LULD, market-wide circuit breakers kick in only in the event of extraordinary market declines of 7% to 20% or more in a single day. The current mechanism was put in force in 2013 to replace an earlier rule that had been in force since the Black Monday stock crash of 1987. 

Instances of market-wide circuit breakers being triggered, resulting in a trading halt, are exceedingly rare. During the early days of the Covid-19 pandemic in March 2020, the breaker was triggered several times due to severe intraday volatility. Before these events, market-wide trading had not been halted due to similar volatility since 1997.  

How We Protect Our Clients

While there are safeguards in place within the market to prevent severe price swings that bear no relation to fundamental company performance or market conditions, we at Milestone take nothing for granted and have put additional measures in place to ensure that portfolios are insulated from these rare periods of high volatility.  

Generally, we purchase mutual funds and exchange-traded funds (ETFs) that provide high levels of diversification across hundreds to thousands of individual companies within a single holding, instead of purchasing individual stocks for clients. This insulates our clients from a number of risks that are particular to individual stocks but that can be virtually eliminated by holding shares of many different companies.  

While mutual funds are priced at the close of each trading day, ETFs are traded intraday and can be impacted by short-term price movements. To protect against abnormal intraday price movements, we buy and sell ETFs using “limit” orders. This way of trading specifies the price we are willing to accept for any given trade. If this price cannot be obtained under current market conditions – such as during a period of very high volatility – the trade does not place and we wait for conditions to settle before buying or selling shares. We also try to avoid trading during the first 30 minutes and the last 60 minutes of the trading day, when volatility can be higher. 

Free Markets vs. Investor Protection

Our markets are built on an ideal of transparency and the free flow of capital. As such there is some tension between the nature of an efficient, free market and the imposition of rules that may appear to restrict the free movement of prices to reflect all available current information. The current rules appear to function well when needed, but exactly how these rules should be structured and where to draw the line between free markets and investor protection remains a topic of debate and research given the stakes involved.  

Investing With the Pros

Investment markets are complex. The news of the day, regulatory developments, changes in the laws, new technologies, and evolving research all impact not only the value of markets but the ways in which markets function. It is easy to become overwhelmed with financial decisions and even to turn away from investing altogether, even though it is one of the best time-tested ways to grow wealth. Thankfully, you do not need to digest market developments and make investment decisions on your own. With decades of experience among our team members, we are here to help you reap the rewards of investing in markets while intelligently managing risk. If you would like to discuss your individual circumstances and how we can help, please reach out to our team.