Investing has always been about making money. But along the way, investors have also had a lot of fun, exchanging stock ideas with friends, analyzing economic reports to assess where the market is headed, and doing their best to stay one step ahead of the pack.
Frankly, there are very few who still enjoy investing like they used to.
Many investors now have a knawing sense that the game is rigged, and have simply focused on low-yield bonds to help build their retirement nest eggs.
After all, how many stock market plunges can a sane person take?
As it turns out, there's a reason behind the growing distrust of the stock market, and you can blame it on the robots.
Fully 75% of all stock trades are made by computers that move at lightning speed to profit from ultra-tiny spreads. (That figure is up from 42% in 2009, according to trading firm Celent.) These trades are often made for very short periods, often as short as a few minutes or even a few seconds.
These 'high-frequency trades' (HFT) are not as benign as they appear. The computers that generate the trends tend to simply mimic what the other is doing, so when some computers start to sell, all of the other HFT computers do the same thing.
That's why a 100 point drop in the Dow quickly becomes a 200 point drop and then a 300 point drop. From August through October of this year, the S&P 500 rose or fell at least 2% on 25 occasions. Many individual stocks have been rising or falling 5% or more on those days.
Those kinds of moves can frighten anyone.
It's not just individual investors that are feeling like the market has lost all logic. Fund managers are also expressing real concern. Mutual funds and hedge funds need a lot of market trading volume -- by people not computers -- to help absorb the impact of their big buys and sells.
Yet non-computerized trading volume is weak and getting weaker. For the first ten months of 2011, the S&P 500 saw roughly 4.4 billion shares trade hands every day, on average. Since November 2, that median figure has been reached only twice. And lower volume means a greater difference between the bid and the ask in a stock price. That spread had been 0.03% of the share price in the first ten months of the year, but has recently widened to 0.05%, according to S&P.
Think of a bid and ask spread as a tax itself. If a stock has a bid ask spread of $50.00/$50.10, then you could buy the stock for $50.10 a share but would only get $50.00 when it comes time to sell. Multiply that ten cent loss by hundreds or thousands of shares and it really adds up.
It's painful enough for individual investors but really tough on fund managers that are buying hundreds of thousands of shares a day.
Is Help On The Way?
European regulatory agencies are taking steps to curb the impact of HFT. The European Union (EU) will require firms that offer HFT services to prove that they have sufficient risk controls in place and they will come under closer scrutiny to gauge whether big market swings are being exacerbated by their actions. Each firm may be limited in terms of the number of trades they can conduct in any given day.
Fortunately, the U.S. may not be far behind. The Securities and Exchange Commission's (SEC) chairwoman Mary Schapiro met with her global counterparts in mid-October in the U.K. to study ways in which the world's major stock exchanges can adopt similar measures.
While a regulatory change in one stock exchange may influence its peer exchange markets, a truly successful reform will require the full cooperation and coordination from all markets. Otherwise, if one stock exchange clamps down, these HFT firms can simply switch to a friendlier venue and continue operating as they always have.
To Tax or Not to Tax?
A simpler measure proposed by some would have these high-frequency trades hit with a transaction tax.
The tax would be small enough to have little impact on individual investors and fund managers that trade reasonable amounts of stock, but would represent a real hit to the HFT firms. Because each high-frequency trade yields a modest 0.01% profit, even a small transaction tax would likely render many HFTs unprofitable.
Think this is unfeasible? In the U.S. stock market, there was actually just such a tax in place until from 1905 until 1981, at which time the 0.02% transaction tax was phased out after heavy lobbying from Wall Street.
Jose Manuel Barroso, who heads the European Commission (EC), is expected to reveal a tax framework for European markets in the coming days or weeks. Such a move has actually been brought up in the U.S. Congress on two occasions over the last two years, but in the current political environment, such a tax hike was quickly shot down.
Another challenge with a transaction tax is, again, getting exchange market cooperation. Any HFT-related transaction taxes need to be adopted by the world's major stock exchanges, otherwise the HFT action will simply shift to the non-taxed market.
Regardless, once the EC lays out its plans, investors will be looking to see how the U.S. responds.
The Investing Answer: With regulators taking a closer look at HFT, investors need to pay attention. Many sense that the market has become a 'loser's game' as all of the computers are now running the show. Yet the landscape may change again in 2012, back in favor of individual investors. Keep your fingers crossed that something gets done...
