The Stock Market is Rigged by High Frequency Traders
This was the headline streaming across all financial media recently after 60 Minutes devoted an entire show to this claim.
In case you missed it, what started it all was a book written by Michael Lewis titled Flash Boys: A Wall Street Revolt which made several claims:
- Human decision making in markets has been completely replaced by high speed computers,
- The ‘complexity’ of the systems is so great that nobody can understand them,
- Half of all stock transactions are controlled by “high frequency traders”,
- All the major investment firms, and, thus you, are being scammed,
- The entire stock market is rigged and everyone who owns stock is a victim!
Wow! How can you NOT pay attention to that claim?
After all, each and every one of us owns stock so we better tune in and find out how we’re all getting ripped off.
What’s Going On Here?
Let’s begin by briefly breaking down where this is all coming from. The issue is “speed”, i.e. the rate by which information is exchanged and, thus, a transaction can be placed.
What should come as no surprise to any of us is high speed cable and computers have increased the speed with which information moves from one location to another. Good news so far.
However, some “devious villains” have now taken it to the extreme and are using this increased speed to jump in ahead of your buy order, thus securing a lower price for their purchase, and driving up the price of your purchase.
These evil high frequency traders are purportedly making ‘millions’ of dollars by buying at a penny or two less than you.
Let’s now peel back the curtain and see what’s really going on here because this is 60 Minutes at their “marketing” best.
Before getting into my thoughts on this, I found it fascinating how 60 Minutes did not name one single person behind any of this. Not ONE. Just unknown evil villains and their computer programs that nobody can understand.
First, speed of information has been the desire of any investor since the beginning of time. The increased speed that information travels is not bad. It’s terrific!
Why Increased Speed Is Good For You
Without subjecting you to information overload, an efficient market is one where multiple buyers and sellers with full information come together to buy and sell shares.
When information moved very slowly (picture the days of ‘carrier pigeons’ and the ‘pony express’) there were smaller numbers of buyers and sellers participating in the market so there was less liquidity.
Given this, the bid to ask price spread on any stock (the difference between what someone is willing to buy vs. the price someone is willing to sell) was huge, especially in small cap stocks.
This phenomenon drives up the price you pay for shares because prices don’t adjust quickly. Think of a transaction in IBM shares taking place in California. When information moved very slowly, someone in Boston wouldn’t learn of the price those IBM shares traded for in California until well after the fact.
However, as the speed at which information is exchanged increased, bid to ask price spreads have come way down thus decreasing the amount you pay per share.
This savings, brought on by speed, is infinitely greater than any potential downside of someone ‘jumping’ in front of your buy and driving up the cost of shares by a fraction of a penny for you.
The Big Picture
Once again, the mass media has painted the picture that investors who do well are doing so because of some unfair ’trading’ practice, i.e. so they can buy and sell at precisely the correct time. Those who win are a select, nameless few who have somehow rigged the system to their advantage because of the creation of a sophisticated and complicated computer program that nobody else can understand. Thus, the rest of us are all just victims who are being exploited.
More important is that, through their firestorm created stories, they condition us that investing is “trading”, i.e. you win by buying and selling correctly.
Investing is not trading.
Investing is “owning”.
Trading is a medium of exchange. In the long run, it has little or no effect on the value of a business in which you have an ownership share.
Given that the challenge we all face is longevity, i.e. having our hard earned money provide us with lifestyle sustaining income for the rest of our lives, we don’t need to concern ourselves with short term trading ploys because we are not attempting to trade our way to prosperity.
We are all in the business of “owning” our way to prosperity.