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Why Michael Lewis Is Both Right and Wrong to Say, “The Stock Market is Rigged”

Recent news has led many to believe the stock market cannot and should not be trusted. But such a belief is both correct and incorrect at the same time.

The terrifying reality
This week, acclaimed author Michael Lewis was featured on 60 Minutes discussing his newest book "Flash Boys." The book dives into the dark world of stock trading, and the various schemes and inefficiencies which guide it.

In short, certain firms like Goldman Sachs (NYSE: GS  ) , Morgan Stanley (NYSE: MS  ) and countless others have realized the speed at which trades are executed at stock exchanges like the New York Stock Exchange and NASDAQ OMX Group (NASDAQ: NDAQ  ) is of immense importance. Being able to execute a trade microseconds faster resulted in a firm being able to bid up the price of a stock someone else was trying to buy perhaps just by a few pennies.

Source: Flickr / thetaxhaven.

While pennies don't sound like a lot, with the volume of trading which goes on in the market, Lewis estimated that this "tax rate" of less than 0.1 percent resulted in nearly $160 million a day being skimmed from the top.

The book profiles Brad Katsuyama, a former trader who discovered this issue and who started an exchange called Investors Exchange which seeks to eliminate the problem.

But Katsuyama, Lewis and others weren't the only one to notice the problems here.

Eric Schneiderman, the New York Attorney General had pledged to investigate and crack-down on high-frequency traders. Regulators including the SEC and CFTC have joined in the probes of the underlying operations. Just this week the Wall Street Journal reported the FBI too would begin investigation into high frequency trading. 

All of this has led Lewis to assert:

"The stock market's rigged. The United States stock market, the most iconic market in global capitalism, is rigged."

He went on to say as a result the victims were "everyone who has an investment in the stock market."

The missing piece
Lewis is absolutely right to denounce the deplorable practices which seemingly scheme billions from the pockets of investors, but the problem is the reality he is missing on critical element, which is the difference between trading and investing.

It should come as no surprise those who engage in trading are facing an incredulous battle to earn money. Four professors found "more than eight out of ten day traders lose money," in a six month period. The Securities and Exchange Commission says simply "Day Trading: Your Dollars at Risk," and goes on to suggest the following are facts surrounding it: 

  • Be prepared to suffer severe financial losses
  • Day traders do not "invest"
  • Day trading is an extremely stressful and expensive full-time job

Blame undeniably lies heavily on the shoulders of the firms under investigation as Lewis outlines, but ultimately trading is a dangerous journey even without the seedy practices which guide it.

Source: Flickr / Hannes Ambrosch.

The correct view
Investing, on the other hand, is approached with an understanding the dollars put into companies through their stock is buying a tangible piece of a company, and sharing in its success and failures. These are not decisions which should be changed daily based on simple movements in prices, but instead those which are guided either by personal diligent research or recommendations from those who can be trusted.

And if neither of those apply, Warren Buffett, one of the greatest investors of all time, recommends a strategy of saving money for retirement through a simple low-cost index fund which mimics the S&P 500. Simple habits of saving and trusting in the market will result in remarkable returns.

If a stock is bought with the intention of holding it for decades or -- at the very least -- years, paying less than 0.1% more will be frustrating, but it should by no means serve a deterrent. In the grand scheme, that amount is immaterial over a lifetime.

In the end, Lewis is right to say trading is "rigged." But investing is not.

The greatest thing Warren Buffett ever said
Warren Buffett is perhaps the greatest example of one who understands the difference between trading and investing. You see, he has made billions through his investing, but he's not afraid to share what he's learned, as he wants you to be able to invest like him. Through the years, Buffett has offered up countless free investing tips to shareholders of Berkshire Hathaway. Now you can tap into the best of Warren Buffett's wisdom in a new special report from The Motley Fool. Click here now for a free copy of this invaluable report.

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  • Report this Comment On April 07, 2014, at 8:27 PM, CMartaus wrote:

    Small individual investors are unlikely to be hurt by these practices. Millions of Americans are invested in mutual funds managed by large brokerage firms, banks, etc. They are being hurt by "front running" and "false bidding" because they deal in very large lots of stock. Check out your mutual fund returns, mine are much lower than they should be. I am considering getting out of mutual funds and into more individual stocks until this travesty is solved. Sadly, this hurts most those least able to understand because they aren't interested in investing and just choose a mutual fund or two through their 401k.

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Patrick Morris

After a few stints in banking and corporate finance, Patrick joined the Motley Fool as a writer covering the financial sector. He's scaled back his everyday writing a bit, but he's always happy to opine on the latest headline news surrounding Berkshire Hathaway, Warren Buffett and all things personal finance.

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