August 10, 2011

August 10, 2011

Simple: Ignore them.

I’m not that old but I can remember the days when it required a human to execute a trade on the floor of the NYSE. Obnoxiously-colored jackets, overpowering voices, and rapid fire hand signals were trader’s competitive advantages of the day. Today, even the love child of pianist Oscar Peterson and gunslinger Doc Holiday wouldn’t be able to compete with computer algorithms. Algorithms are the new competitive advantage in day trading. Accept it, deal with it, and move on!

These disruptive technologies known by names like high frequency trading (HFT) and low-latency trading (LLT) are taking over the global exchanges. Throw in the latest craze of ETFs designed to move two and/or three times as much as a particular index, and volatility shoots through the roof on the outlier days in the market.

According to Boston-based consulting firm Aite Group, in 2006 one-third of EU and US stock trades were computer generated. By 2009, nearly three-fourths of all US equity trades were automated. During the biggest trading day in history up to that point, in September 2009, ETFs reached an unprecedented 40% of trading volume. This rapid ascent of HFT and LLT would make Adam Smith both proud and nervous.

That’s because Adam Smith’s Wealth of Nations was all about how human nature and the natural laws of behavior will ultimately find the most efficient solution to a problem if left alone (i.e., little or no third party interference). Mr. Smith might correctly point out that computers can do a better job than humans when it comes to taking advantage of mispriced securities, making him proud. I happen to agree with this simplified position. Yet he’d be nervous, as am I, about the lack of human interpretation pervasive in today’s markets. Smith’s brilliant analysis requires human behavior to be part of the mix. HFT replaces partially emotionally-based behavior with pure logic. HFT and LLT may be quicker, but quicker doesn’t equate to smarter.

The famous $61 to $47 back to $61 move in P&G on May 6, 2010 during the Flash Crash is a perfect example of why computers aren’t smarter just because they are faster. Though P&G did trade at $47 for a millisecond on May 6, it wasn’t reality based. It was a fictitious amount created–and corrected–by trading programs. A line of computer code decided to sell at $47 and another line of code decided to buy. At the end of the day, P&G’s value had barely changed, human’s were given a few hours to make sense of the carnage, and sanity returned to pricing.

Back to the issue at hand. How can the everyman compete with these trading programs? Ignore them. Ignore the volatility. Ignore the violent swings. And most of all, don’t try to compete by day trading. You’ll lose. Colocation servers, genius algorithms, and Moore’s Law have sealed the fate of human traders. The only solution for the everyman is to return to fundamentals. Make buy and sell decisions based on a discounted value of a security’s future cash flows. It’ll make investing greats like Ben Graham and his famous disciple Warren Buffett proud and you—the everyman—wealthier. Trust me.