I found myself grunting and muttering in dismay while reading “The stock market is run by wild robots we don’t fully control,” (print: The Money Machine) by Sally Adee, NewScientist (14 October 2017, paywall), which had some poorly articulated concerns about the stock market. For instance, this:
To understand why machines are taking over, it helps to look at how perceptions of the stock market have changed following the financial crisis of 2007-08. It is increasingly clear that for the average person, investing is a mug’s game. Individuals have little hope of picking successful firms to back, while giving your money to investment managers who aim to beat the market often sees any gains being eaten away by a laundry list of opaque fees.
While the mutual fund game is indeed beset by a tide of hurdles to find effective actively managed funds, it’s not impossible to find them. But let’s address the other side, the individual investing in individual stocks.
First of immediate concern is the investment philosophy. The machine algorithms, by and large, are concerned with extreme short-term investing wherein microseconds or even smaller quanta of time are of critical importance and stocks may only be owned for a few seconds. The individual attempting to compete with the machines at this level are indeed mugs, or even madmen.
But while you may think the madness lies in attempting to compete with high speed machinery, that is not my point, even though you’d be right. My point lies in returning to the purpose of stock ownership and the stock market.
Owning stocks is all about having a partial ownership of a company. The stock serves several purposes: it permits the raising of funds for corporate purposes that might otherwise have to be borrowed from lenders at unattractive rates; it dilutes the risk to the owners; etc. The stock market is a way to estimate the future of companies by pricing the companies via their stocks, resulting in a market capitalization. The differences in knowledge and opinion form the basis for the pricing differentials that allow stocks to be traded at all.
But let’s pause here and reflect on a facet that seems to receive short shrift in most stock market summations, and that’s social utility. That is, what activities within the market have social utility, are advantageous to society? Those explicit purposes I mentioned are mutually believed to have social utility.
But what social utility do the algorithms have, stipulating their purposes is high speed trading with low-duration ownership? Answer: I don’t see any. My observation suggests they merely seek to profit from the gaps in information gathering by competitors, buying or selling stocks nano-seconds before prices shift.
In essence, profiting from the long-term success (or failure, for those who short a stock) of firms is not the purpose of the trading firms using these algorithms, and because they’ve discarded these goals, their social utility appears to be approaching zero.
I would be interested to see a discussion of requiring all stocks traded on the American-based exchanges be held for a minimum of a day.
All that said, let me follow the rule of playwrights and mention the name of our lead character for a third time: algorithms are used for short term trading. So what does an individual investor do?
First of all, don’t compete with them. Long-term investment still appears to be not only a viable strategy, but one which is far more successful for the average investor than short term investing. Or so they were saying twenty years ago on The Motley Fool, and I believe they will still tell you the same thing, with the requisite academic references. Algorithms, from what I’ve read, do not compete in the 5 year minimum holding horizon game. The successful investor will buy and hold for the long term, and will choose firms that have a demonstrated view of the future with proven management. Adee’s view is, with all due respect, a pessimist’s view.
Second, this isn’t a game. If you don’t “beat the market” one year, does that make you a miserable failure as an investor? No, of course not. Like any good student, you evaluate what happened, try to decide if you made mistakes, were caught up in some irresistible wave of history, or if this year was just a normal part of the up and down all investors experience. I’ve had a number of investments in which I was “under water” for years, but when the company and its stock caught fire, it really went up and erased my “paper losses” in a matter of months. I’ve acquired the patience to hold on through bad times; my continuing problem is when to sell.
Third, the status of your portfolio at any particular time is meaningless. Many folks invest with their emotions on the line, and that’s disaster. They look at their portfolio, down 30% on the year, and all they can think of is all that money they could have spent on booze and cigs. But portfolios are rarely liquidated en masse, but rather one stock at a time as needs arise. The simple fact of the matter is that a majority of the years of investment could look awful, but because most of the stocks are liquidated as winners, the end result is a successful portfolio over its lifetime.
So the article continues on to a comparison with ecology, suggesting that passively managed funds (i.e., index trackers) are analogous to monocultures, and may have the same vulnerabilities. It’s an interesting thought, I must say, although opposing views are presented, and not being an expert, I’m content to ride along in their wake.
But this whole thing reminds me of the early days of hedge funds, and the near-failure of Long-Term Capital Management. From Investopedia:
The most famous hedge fund collapse involved Long-Term Capital Management (LTCM). The fund was founded in 1994 by John Meriwether (of Salomon Brothers fame) and its principal players included two Nobel Memorial Prize-winning economists and a bevy of renowned financial services wizards. LTCM began trading with more than $1 billion of investor capital, attracting investors with the promise of an arbitrage strategy that could take advantage of temporary changes in market behavior and, theoretically, reduce the risk level to zero.
The strategy was quite successful from 1994 to 1998, but when the Russian financial markets entered a period of turmoil, LTCM made a big bet that the situation would quickly revert back to normal. LTCM was so sure this would happen that it used derivatives to take large, unhedged positions in the market, betting with money that it didn’t actually have available if the markets moved against it.
When Russia defaulted on its debt in August 1998, LTCM was holding a significant position in Russian government bonds (known by the acronym GKO). Despite the loss of hundreds of millions of dollars per day, LTCM’s computer models recommended that it hold its positions. When the losses approached $4 billion, the federal government of the United States feared that the imminent collapse of LTCM would precipitate a larger financial crisis and orchestrated a bailout to calm the markets. A $3.65-billion loan fund was created, which enabled LTCM to survive the market volatility and liquidate in an orderly manner in early 2000.
Since this occurred during the Clinton years, I must assume the Clinton Administration was responsible for the mistake of saving LTCM from tasting the bitter ale of failure, one of the earlier examples (for the current generation of government haters) of government interfering to save the rich from their mistakes. Of course, the article suggests this was done for the greater good, but I’d argue that this action was a great mistake in that we only learn from the backlash of our mistakes. If LTCM had been permitted to crater, the subsequent market quivers would have acted as vivid reminders of why permitting firms to become too large is a danger not only to the members of the firm, but to the market as well. I do not know if that was of the factors in embittering the small investor and non-investor towards government, but I would not be surprised if it did.
