Computerized Trading and the Individual Investor

 

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I’ve been asked about computerized trading.  Sometimes called “program trading,” it was blamed for the market’s extreme movements late last month.  It is not the whole story, as I wrote in my post  at the time, but it was a factor.  My questioners ask if they should account for it in their trading.  The simple answer is: NO.  Here are four reasons:

  1. For all its high-tech associations,computer-based trading is really just a high-tech, algorithm example of herd behavior of the sort that has, in various forms, always typified financial markets. Investing in response to computerized trading only makes the investor one of a herd – never a way to make money in any financial area but especially so in stocks. Trying to anticipate the turn is akin to standing in front of a cattle stampede betting your life that you know when, and which way, it will turn.  You could get lucky, of course, but more likely you’ll be trampled.
  2. Program trading increases market volatility, exaggerating its moves up and down, but in general it has little impact on prices over time. To the fundamental investor seeking to meet the basic objectives described in this post and this one, it is an irritation, but should not be considered anything more.  The market in the closing weeks of 2018 demonstrates 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.
  3. Individual investors who buy into and out of stocks ahead of such 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.  (In fact most of these operations have their computers physically near the exchange, because a profit opportunity can be missed in the time it takes to get an electronic order to the exchange from, say, an office in Connecticut.)  And even at such speed, they can only make money by squeezing pennies or less out of a single transaction; it is only worthwhile for them because they deal in inordinately large volumes of stock.
  4. Computerized trading violates a fundamental rule for the retail stock investor: Even without the added volatility of computerized trading, stocks exhibit considerable volatility. This fundamental aspect 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 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.  Go into bonds or savings accounts; look at this post for more detail.