Is the Stock Market Rigged?

Yes, when it comes to things like high-frequency trading, says Bill Mann. But that doesn't have to affect you as an investor.

May 5, 2014 at 8:00PM

"Beware those who seek constant crowds, for they are nothing alone."
-- Charles Bukowski

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

So says Michael Lewis. His most recent book, Flash Boys, has drawn a huge amount of scrutiny to what really isn't a new problem: high-frequency trading, or HFT. It's a debate that's been going on for some time on Wall Street, and we should be grateful for Lewis' storytelling ability to make such an arcane topic accessible to the general public.

The attention and scrutiny given to Flash Boys has resulted in the definitive answer to one question: "How can an author sell a lot of books?"

On other questions, there is unlikely to be a definitive answer, in part because of what is the most fascinating revelation of the debate so far: No one really knows how the stock market actually works.

To me the question is whether HFT is a malevolent force -- and I believe that it is. Further, I believe that the actions of the players are much more important than what they say. So while this debate will certainly focus on what Lewis got wrong (and make no mistake, he did get things wrong), those who profit from HFT will attempt to use those errors to extrapolate that Lewis' entire premise is wrong. In classical rhetoric, that's known as a "fallacy of stupidity."

Here's my own primer. It is basic and also certain to be wrong in parts (see "no one really knows," above).

1. The markets are, and have always been, about speed. There's a reason traders don't stand around the Buttonwood tree anymore, and why the stock market scene from Trading Places now looks so anachronistic. Electronic trading has made the buying and selling of stocks (and other financial instruments) more efficient, lowering spreads, and trading costs for everyone. HFT is a kind of electronic trading, but the two are not the same thing. I don't think that things like sub-second trading add much to the market (where "much" equals "liquidity"), but I sincerely doubt that this is the source of many problems, either.

2. Market participants have always accessed the market at different speeds. Some people traded by telegram while others went to telegraph. Others had phone access, then dial-up modem access, then broadband, then direct fiber collocated at the exchange. No competent argument should posit that access speeds to the markets should be identical for all participants because this is impossible. And dumb.

Market participants have similarly always used these speed differentials to their advantage. It's why companies set up massive day-trader pits in the 1990s. In our business of running mutual fund portfolios, we have certain algorithms that we use to trade to maximize efficiency. In a pari-mutuel system, maximized efficiency has always and will always come at the cost of the inefficient.

But a few years ago something changed, and to me it is at the center of the argument. The exchanges themselves (NYSE, Nasdaq, etc.) started providing information faster to those who paid for it, and also gave them the ability through their own algorithms to jump in front of other participants. By "faster" I mean that we're measuring in tiny fractions of seconds, but it's enough.

Those who insist that HFT is no big deal and actually adds efficiency and liquidity to the market have a hard time describing why this is cool. The fastest traders could simply make money by being the fastest, by having preferential access at the exchanges themselves. They don't care what they're trading -- Apple stock, frozen concentrated orange juice futures, whatever. They take advantage of their latency advantage to jump in front of other market participants -- and that latency is provided by the exchanges themselves.

That's what's different about HFT. The exchanges have sold certain participants privileged access and in turn pay those same participants to create volume, creating a situation in which HFT firms can pretty much make a guaranteed profit on every trade. A super-tiny profit, yes, which is why the HFT firms must make millions of trades a day. That's why they're called "high-frequency traders." HFT firms are investing hundreds of millions of dollars, and paying the exchanges enormous sums to get in front of the line, and we are to believe that this is a benign market function?

Basic business sense should tell you what's up here. The HFT guys are not stupid. The algorithms they create are mind-bendingly complex. And if they are going to invest such huge sums for preferential speed and access, they will demand (as they should) a satisfactory return on their investments.

I don't even blame the HFT guys here. The real villains, in my mind, are the exchanges themselves. I've argued a few times in these pages (most recently in Question Authority, Jan. 17, 2014) that one of the most dangerous things that's happened over the past 20 years in investing is that the exchanges themselves converted from private partnerships to publicly traded entities.

In my mind, having a quarterly number to hit to satisfy stockholders has given exchanges an almost irresistible incentive to compete with one another to maximize profits. And on occasions where you're just lowering your standards a little bit (See "reverse merger," "Chinese," "small caps," almost all of them as an example), then shareholder protection and fairness become that much more expendable. Self-interest does a strange thing to people. It corrupts.

So this leads to two questions:

  • "Is the market rigged?"
  • "Does this hurt me?"

As to the first, my answer is an unequivocal "yes," followed by "and this isn't new." HFT, as practiced by the exchanges' selling of asymmetric access to certain market participants, simply isn't fair. The HFT algorithms essentially attempt to influence the price of the market through tactics like "quote stuffing," which is about like it sounds. What we don't know is how far these market participants are willing to go to distort the market to their advantage.

The second question is much more important. Systemically, things that cause market participants to lose faith in that market are probably bad. But there are lots of things that manipulate stock markets. Federal Reserve policy is all about influencing investor behavior. So is capital-gains tax policy. It's possible that you've had a few pennies harvested from you during a trade.

There is an obvious solution to combat this: trade less. Be a long-term holder of businesses. Focusing on HFT as a reason to be in or out of the market is absurd. The stock market isn't Vegas or some crooked numbers game. It's a tool that allows ordinary folks like us to buy pieces of businesses, which, if you're doing it right, tend to appreciate in value. Some lose, yes, but ultimately your investment returns are overwhelmingly going to be driven by what investments you hold.

It's the Joshua Principle: "A strange game. The only winning move is not to play." Worrying about HFT as an individual investor is like worrying about sunspots. Yes, they might be bad for you, but not nearly as unhealthy as your three-chalupa lunch was. Frankly, out-of-control management compensation is a far, far bigger drag on your long-term investment returns than HFT could ever dream of being. Worry about that.

Returns in investing come from buying something for $1 and selling it for a lot more. If HFT causes you to buy it for $1.00000001 instead, is that really, truly harmful when you sell it for $2.63 years from now? Trading has both overt and hidden expenses to it, and those expenses can add up over time.

Speaking of "over time," in aggregate, stocks go up in value, over time. If you're buying and selling stocks in a hurry (or holding mutual funds that frequently turn over their asset base), you're leaving yourself more susceptible to the machinations (and manipulations) of the stock market. If you aren't, you aren't. Simple.

And read Michael Lewis' book. Whether it has wrongness built into it (and it does), it will give you an idea why our stock exchanges are threatening to surpass both Congress and the NCAA on the cravenness scale. They're the villains in this story, because they're supposed to promote fairness.

Bill Mann has no position in any stocks mentioned. The Motley Fool recommends and owns shares of Apple. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

Money to your ears - A great FREE investing resource for you

The best way to get your regular dose of market and money insights is our suite of free podcasts ... what we like to think of as “binge-worthy finance.”

Feb 1, 2016 at 5:03PM

Whether we're in the midst of earnings season or riding out the market's lulls, you want to know the best strategies for your money.

And you'll want to go beyond the hype of screaming TV personalities, fear-mongering ads, and "analysis" from people who might have your email address ... but no track record of success.

In short, you want a voice of reason you can count on.

A 2015 Business Insider article titled, "11 websites to bookmark if you want to get rich," rated The Motley Fool as the #1 place online to get smarter about investing.

And one of the easiest, most enjoyable, most valuable ways to get your regular dose of market and money insights is our suite of free podcasts ... what we like to think of as "binge-worthy finance."

Whether you make it part of your daily commute or you save up and listen to a handful of episodes for your 50-mile bike rides or long soaks in a bubble bath (or both!), the podcasts make sense of your money.

And unlike so many who want to make the subjects of personal finance and investing complicated and scary, our podcasts are clear, insightful, and (yes, it's true) fun.

Our free suite of podcasts

Motley Fool Money features a team of our analysts discussing the week's top business and investing stories, interviews, and an inside look at the stocks on our radar. The show is also heard weekly on dozens of radio stations across the country.

The hosts of Motley Fool Answers challenge the conventional wisdom on life's biggest financial issues to reveal what you really need to know to make smart money moves.

David Gardner, co-founder of The Motley Fool, is among the most respected and trusted sources on investing. And he's the host of Rule Breaker Investing, in which he shares his insights into today's most innovative and disruptive companies ... and how to profit from them.

Market Foolery is our daily look at stocks in the news, as well as the top business and investing stories.

And Industry Focus offers a deeper dive into a specific industry and the stories making headlines. Healthcare, technology, energy, consumer goods, and other industries take turns in the spotlight.

They're all informative, entertaining, and eminently listenable. Rule Breaker Investing and Answers are timeless, so it's worth going back to and listening from the very start; the other three are focused more on today's events, so listen to the most recent first.

All are available for free at www.fool.com/podcasts.

If you're looking for a friendly voice ... with great advice on how to make the most of your money ... from a business with a lengthy track record of success ... in clear, compelling language ... I encourage you to give a listen to our free podcasts.

Head to www.fool.com/podcasts, give them a spin, and you can subscribe there (at iTunes, Stitcher, or our other partners) if you want to receive them regularly.

It's money to your ears.

 


Compare Brokers