The headline on a new study from economist Andrei Kirilenko is being promoted as something like "High-Frequency Trading Hurts Small Investors," but the title is misleading. While high-frequency trades now account for close to half of all the trades made during any given day, I don't believe they pose a meaningful threat to the small investor. Kirilenko relies on a flawed premise to get to his conclusion, and succeeds only in adding more fuel to an already roaring fire. But while we sit and warm our hands, we distract ourselves from the real challenges of investing.
Whose side are you on?
When I talk about hurting investors, I'm really worried about the small, non-professional investor. There have been other claims that institutional investors are hurt in other ways, but today we're going to focus on the little guy -- and he's got nothing to worry about. That might seem counterintuitive; after all, we're talking about going up against huge teams of number-crunching machines that execute multiple trades every second. But the success of those trades doesn't mean the little guy loses.
One of the keys to Kirilenko's new report is that he thinks of the market as a zero-sum game -- in order for one side to win, the other has to lose. But I think he's got it wrong. The market isn't zero-sum, and high-frequency trading isn't cheating. In fact, we're all winning the lower transaction cost game thanks to the infrastructure and efficiency of some of those big high-frequency businesses. The systems that companies like Knight Capital (NYSE: KCG ) -- which lost close to $450 million in a trade gone awry this year -- employ have pushed costs down for retail investors, and their research has helped make general transactional software more efficient.
The bad rap is hard to beat
So it seems like, as small-timers, we'd be applauding the high-frequency firms. Yes, things do go wrong, just like with any other trading system. High-frequency trading creates a lot of noise in the marketplace, and some of that noise may be intentional. One study found that occasionally, less than one order out of 100 sent will actually be acted on, with the rest of the orders being canceled. But traders say that the excess orders are just market feelers, which gauge the liquidity of stocks and give the algorithms a more accurate understanding of pricing.
No matter what all those extra orders are meant to do, sometimes they have dire consequences. When Facebook (NASDAQ: FB ) IPOed earlier this year, the sheer volume of orders temporarily shuttered the market, causing the exchange to have to halt trading. But high-frequency trading didn't make Facebook a bad company or a good company. It didn't affect Facebook's long-term prospects, and it didn't have any impact on the small buyers who buy good companies -- investors in the traditional sense.
Maybe what investors really don't like is that high-frequency trading makes the market more unstable. We all remember the so called "flash crash" from 2010, when the Dow dropped 9% in mere minutes, and then regained the lost ground just as fast. While that incident hasn't been strictly tied to high-frequency traders, there is no doubt that the problem was exacerbated by their activity. But, while things may happen more quickly, volatility doesn't actually increase in the market due to high-frequency trading. A study from the U.K.'s Foresight Project, found that high-frequency trading didn't increase overall market instability.
Everyone loves a good excuse
So if we're not worried about high-frequency trading causing market volatility, and we don't think that we're being cheated, and if the systems that the traders use actually make things cheaper for us, why can't we get on with our lives? I think it's because those anonymous algorithms make us feel better when we make mistakes. We can point to hedge funds, or big banks, or high-frequency trading as the thing that messed it up for us. We can try to ignore that management was horrific, or that the product had no competitive moat, because the stock fell due to some completely unforeseen force.
But excuses don't pay anyone's bills -- except political speech writers. Instead, let's focus on what we should be doing in the first place. Let's follow the advice of a low-frequency guy: Warren Buffett. Always a giver of sage advice, Buffet famously said, "It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price." Blaming high-frequency trading for our inability to recognize a wonderful company and a fair price doesn't make us better investors. As usual, it pays to stick to what we know best, and ignore what we can't control. In that vein, Morgan Housel's 9 Financial Rules You Should Never Forget makes for a reassuring read, no matter how good you think you are.