Computerized stock trading has played a not-insignificant role in recent violent stock market swings. Of course, behind these swings are the perennial drivers of market lurches: fear and greed. Fear rules whenever investors feel insecure or uncertain, but it’s greed’s turn when investors judge that the fear has created a buying opportunity that despite uncertainty and insecurity, they feel they cannot afford to miss. But computerized trading exaggerates what otherwise might be significant swings into wild volatility. We have been seeing a lot of this.
The computer’s role exaggerates market swings because most if not all of the algorithms running these programs react to the momentum of the market. If investors begin selling out of fear and stock prices fall at a particular rate or beneath a certain point, the computers “see” further losses and “order” even more sales, thus ensuring that further losses take place. Investors rushing to buy a stock will trigger the computer programs to join in. These investor moves, once they prompt the algorithms to act, become self-fulfilling and greatly exaggerated.
For those who find this unnerving, here are four things to keep in mind:
- For the computer, eternity begins and ends each day. They go with the momentum until the market closes (or, less likely, something like human action alters the momentum despite the influence of computer trading). The computer action does not follow from one day to the next.
- Though computerized trading exaggerates up and down moves, it has no effect on prices over time. Such trading can be an irritation for the fundamental investor seeking to meet the basic objectives often referred to in these posts, but don’t consider it anything more than that. The market in the closing weeks of 2018 certainly demonstrated this: Computerized trading pushed the downdraft in stock prices much further than it otherwise might have gone, and then exaggerated the upswing the following day. The same thing is happening now.
- Individual investors who try to gain from computer-induced swings by buying and/or selling stocks ahead of the swings are as likely to lose as to win. Traders buying and selling algorithmically make money because computerized trading enables them to move blindingly fast –– faster than most professional investors and certainly faster than any retail investor –– that would be you. (In fact, most of these operations have their computers physically near the exchange, because a profit opportunity can be missed in the less-than-instantaneous time it takes an electronic order to reach the exchange from, say, an office in Connecticut.) Even at such speed, algorithmic traders can only make money by squeezing pennies or less out of a single transaction; it is worthwhile for them because they deal in huge stock volumes. No individual investor can do this.
- Computerized trading violates a fundamental rule for the retail stock investor: Even without the added volatility of computerized trading, stocks exhibit considerable volatility. This is a fundamental aspect that should warn investors off stock investing if there is any chance they will need their invested money in a hurry. If you cannot wait for the market’s ups and downs to cancel each other out and give you the long-term positive gain of stocks, then you should not be in them in the first place. Better to be in bonds or savings accounts.