The Real Story About Investors and Trading Fiascoes

The good news is, people aren't freaking out. The Knight Capital (NYSE: KCG  ) debacle is just the most recent in a series of the innocuous-sounding "market events" which includes the flash crash of May 2010 and the Facebook IPO meltdown. It's supposed to be enough to make even the most intrepid investor wary. So why isn't it changing the way we invest?

The sky is falling
Following the Knight Capital crash, media coverage focused on the flaws in high-frequency trading. Days later, the coverage turned toward investors, with The Wall Street Journal, The New York Times, Financial Times, Fox News, and many others shaking their heads in consternation at the ordinary investors who supposedly keep getting burned by playing with the grown-ups. "When Will Retail Investors Call it Quits?" asked Jason Zweig of The Wall Street Journal. The subtitle of the piece could have easily been an exasperated "Sheesh."

Frank Maselli, broker and owner of the Maselli Group, isn't exactly pleased with the coverage. "The financial media's need for constant controversy [makes it] a very tough time to be a retail investor."

In the Knight Capital scandal, there's plenty of blame to go around. But context is king, and nowhere is that truer than when evaluating investor confidence.

A crazy casino where the rules change by the minute
"No matter what your opinions are on the current state of market structure, having a firm that controls about 10% of share volume suddenly disappear from the market is not a confidence booster."

Such is the introduction of "The Sky is Falling: US Equities Market Structure Confidence Survey," which measured institutional confidence following the Knight Capital debacle. TABB Group conducted similar surveys following the Facebook IPO and the May 2012 Flash Crash, and has also studied high frequency trading and regulation in Europe.

Adam Sussman, a partner and director of research at TABB Group and author of the report, writes, "Broker/dealers hold primary responsibility for solving market structure complexity on behalf of clients. If their confidence has weakened, does that also point to a lack of conviction in their abilities?"

Does it? I asked Sussman this during a recent interview. He replied, "I think if you ask brokers, they would all say they're confident because of their obligation to provide best execution. They probably think they're doing the best they can given the hand they're dealt, but they probably don't think they're being dealt a fair hand."

The theme of the stock market as a game of chance is one echoed by Maselli. "Extreme volatility and the seeming capriciousness of market action make the financial world feel like a crazy casino where the rules change by the minute," he said.

The slow, deliberate exodus
Brokers and institutional investors who have lots of ordering risk may be worried. But what about ordinary, long-term investors? Given the portrayal of markets as a crazy casino trading, and journalists who are surprised anyone would still be in stocks, it wouldn't be a surprise to see a mass exodus of retail investors from the stock market into something more stable. Like bonds. Or plastics.

In fact, that exodus is a common theme in reporting about the stock market these days. The evidence usually comes in the form of Investment Company Institute data showing that stock mutual funds are seeing heavy outflows.

But Shelly Antoniewicz, a senior economist at the ICI, says the rate of domestic equity outflows over the past six years doesn't seem to have been affected by trading glitches.

"We looked to see if there were substantial outflows in the weeks or months following the flash crash from domestic equity mutual funds and quite frankly, we didn't see anything that was above and beyond what we'd already seen," Antoniewicz said. "To say these outflows are related to a flash crash is a little myopic and doesn't look at the longer-running trend."

Part of that longer-running trend is that investors have more options than ever before. Investors who left domestic equity mutual funds have gone into ETFs, international equity funds, bond mutual funds, and hybrid mutual funds, which blend equities and bonds. Additional factors include America's changing demographics as baby boomers retire, the increasing availability of age-appropriate target-date funds, and an growing number of investors less willing to assume risk.

When mitigating loss backfires
For investors who are still heavily invested in stocks, an algorithmic trading glitch or flash crash won't register until after, if at all. So far, the stock market has tended to self-correct and the impact to portfolios has been minimal, if not non-existent.

There is an exception to that theory, of course, and that's the stop-loss sale order, which triggers an automatic sale when a stock falls to a certain price. By the time an investor notices their stock has been sold, the price may have stabilized, ultimately resulting in a large loss. For example: Apple, currently selling at $670, drops to $300. A stop-loss sale is triggered, the shares are sold. When the glitch is fixed, most likely within minutes, shares have stabilized, and the customer must either buy back the stock or walk away.

Jim Martin, a financial advisor at New River Financial Group, said the flash crash changed how some of his clients trade. "Some clients saw those orders execute during the [Knight] flash crash only to see the positions recover within hours, while they had already sold." The result was a resounding loss.

Sussman offered an even more blunt response. "People shouldn't use stop loss orders," he said. "I wouldn't go to the SEC and tell them to ban stop loss orders, but if I had a brokerage firm, I would not let people use stop loss. There are smarter ways to protect your portfolio."

Rewriting a present history
Investors who have survived a trading glitch intact are not off the hook entirely. Even after the market has stabilized, potential investors will glance back over a stock's performance and see the peaks and valleys that are caused by trading abnormalities, and perhaps misattribute the volatility to the stock itself.

"In two years, is anyone going to remember, 'Oh yeah, it was Knight Capital's crazy algo[rithm] that pushed the stock price up 10% that day?'" Sussman asked. He continued:

The prices we see in the market place aren't all based on rational supply and demand. Some of the prices are based on whether it's an algorithm gone wild or a market meltdown, so how do investors remember that? Do we have to be more wary of that now because we've had these series of events?

Trading vs. investing
How the average investor is affected by a flash crash or trading glitch will depend entirely on his or her investing strategy. Buy-and-hold investors who carefully research a company's assets, management, and long-term potential before buying won't be affected by minor (or even major) blips in the market. Acts of the market are independent of a company's performance.

Traders, who buy and flip, or hold stocks for days or months, will be naturally more affected by market fluctuations. Customers with stop-loss sales may be burned. The quick profit on a stock sale will become as elusive as a house flip during the mortgage crisis. But buying stocks, rather than renting them, renders such market events nearly irrelevant to a portfolio's overall performance.

Fool contributor Molly McCluskey owns no shares of the companies mentioned above. The Motley Fool owns shares of Apple. Motley Fool newsletter services have recommended buying shares of Apple. Motley Fool newsletter services have also recommended creating a bull call spread position in Apple. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.


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