Tuesday, August 30, 2011

Why You Can't Beat the Stock Market Through Active Trading

By John F. Wasik (Reuters)

The days of you trying to make a buck actively trading in the stock market are over.

Individuals don’t stand a chance anymore because they are largely competing against rational machines often guided by herd-like irrational forces. The robots can rule in the blink of an eye.

I’m not spouting lines from an Isaac Asimov novel, but citing reality. The machines and people who program and profit from them have won — for now.

I knew it was over for human traders when I heard that high-frequency trading firms were hooking up their data lines directly to exchange computers to gain an extra hundredth of a second in execution time.

High-speed programs are designed to move millions of shares in a fraction of a second to take advantage of small movements in securities prices. These algorithms are ideal Wall Street workers. They don’t need health insurance and you don’t have to pay them bonuses to help finance their Lamborghinis or homes in the Hamptons.

There’s no way to beat the machines, unless of course, you have a faster machine, better programs or the ability to predict the future. Your odds are better in Vegas, which never had great odds for a palooka pulling a one-armed bandit.

Who are you trading against when you take on the machines? Any entity from a boutique investment firm with a handful of “quants” — math majors who flocked to Wall Street for the big bucks — to a mega-bank or hedge fund. Some 60 percent of the volume of the New York Stock Exchange is attributed to high-speed trading, maybe more.

Although many market observers blamed machine traders for a flash crash last year, regulators have done little to slow down these speed demons.

Machine traders don’t even need a human analyst to pull the trigger on trades based on the day’s news or price changes. Who watches CNBC any more in these firms? They don’t have to: Machine-readable feeds from all of the news services and exchanges go right into their computers and trading decisions happen without much direct human intervention.

The trading floor is becoming as relevant as the telegraph system.

That’s why will see even more flash crashes and huge price swings called “mini-flash crashes.”

The only perennial truth about the stock market is that it will remain volatile and virtually unpredictable because it’s based on the mass actions of millions of people. It’s like trying to predict the direction of a giant school of dumb fish.

Every day, even more money is chasing potential price swings at the speed of light all over the world. The more traders adopt these systems, the greater the chaos.

There are, of course, various ways of protecting your money from the market madness. Crafting a low-risk, long-term portfolio allocation of stocks, bonds and alternatives for your age, lifestyle and risk profile is one way.

For long-term stock investors, you’ll be better off in exchange-traded funds like the Vanguard High-Dividend Yield fund or the SPDR S&P Dividend fund. Both offer a portfolio of high-dividend paying stocks.

You can also create a high-dividend portfolio of your own, but you’d need to diversify across at least a dozen industries to buffer sector risk.

Dividends generally aren’t impacted by high-speed trading. If a company has sufficient earnings, they cut you a check every quarter. Once you create your portfolio (with individual stocks), you’d enroll in dividend-reinvestment programs to buy new shares on a regular basis on a dollar-cost averaging basis. That would ensure you wouldn’t be buying in at the market peak. The majority of these programs allow you to buy new shares commission-free.

Don’t even try to time the purchase of your stocks, because Washington will do nothing to protect you against huge market swings.

Wall Street is spreading plenty of money around in lobbying efforts to make sure that their trading desks don’t get regulated in any meaningful way. Sated with financial services industry contributions, House Republicans have already spent most of the year trying to kill Dodd-Frank financial reforms, so high-speed trading isn’t even near the top of their agenda.

So my advice couldn’t be more succinct. The best way to beat the machines is pretty simple: Don’t even play them. Game over.

1 comment:

rewinn said...

The larger question is this: for what are these program optimized?

Some have said that stock markets are good because they optimize allocation of scarce capital, and that might have made sense back when trade were based on things as quaint as analysis of corporate fundamentals, with an intent of holding stocks for months or years.

But a program that buys, sells and buys again within seconds doesn't really care about whether the traded company will be around in the next minute, much less the next year; efficient allocation of capital is meaningless. The sole criterion for activity is the speed and volume with which wealth can be concentrated.

This is serious business.