The rise of high-frequency and quantitative trading is both an extreme manifestation of and a contributing factor to a stock market in which the bulk of activity is short-term oriented. It has little in common with investing. The good news is that even long-term investors can take advantage of one of the positive effects of this transformation, but they'll need to take a few precautions to mitigate some of the new risks they can expect to encounter in today's microsecond market.
A long-term investor gets freak-ency
In April 2010, index fund giant Vanguard, a tireless advocate on behalf of individual investors, responded to a call for comments from the Securities and Exchange Commission on a concept release on equity market structure. Despite being at the extreme opposite end of the spectrum in terms of investment philosophy, Vanguard produced a spirited defense of high-frequency trading, arguing that it has contributed to a substantial reduction in transaction costs:
While Vanguard does not engage in [high-frequency] trading, we recognize that such trading has a positive impact on the markets at large, including longer term investors. Such arbitrage trading enables investors to get a fair price across market centers. Vanguard believes that the market structure changes facilitated by the Commission's various regulatory initiatives and the "knitting" together of the marketplace by "high frequency trading," have led to a significant decline in transaction costs for long-term investors over the past ten years through increased liquidity and tighter bid-ask spreads... We conservatively estimate that transaction costs have declined 50 bps, or 100 bps round trip [over the last 10-15 years]. This reduction in transaction costs provides a substantial benefit to investors in the form of higher net returns.
Now, we at The Motley Fool like lower costs. All other things equal, a reduction in costs translates directly into higher investor returns. The question remains whether lower trading costs is an unmitigated good for investors and the market as a whole. For example, it's conceivable that lowering the cost of transacting may have the unintended result of lowering the conviction threshold investors need to reach before taking a buy or sell decision. After all, the cost of annulling a "mistake" by closing out the trade is lower. In that context, we might expect buying and selling activity to increase and investors' average stock holding period to fall.
The hidden cost of low-cost
In a paper titled "Transactions Costs and Holding Periods for Common Stocks," Allen Atkins and Edward Dyl of the University of Arizona looked at the average holding periods and bid-ask spreads for Nasdaq stocks from 1983 through 1991 and for NYSE stocks from 1975 through 1989. They found strong evidence that the length of the holding period was positively related to the size of bid-ask spreads (namely, shorter holding periods went along with narrower spreads). Other researchers have also found the same relationship in the Hong Kong and Finnish stock markets.
That trend has continued in the 15 years since the paper's publication. The following graph from investment bank Societe Generale shows the average holding period for a stock listed on the New York Stock Exchange in the 20th century through 2011:
From hold 'em to churn 'em
Since it peaked at 8.3 years in 1957, the average holding period has been in secular decline, bottoming out at roughly 9 months in 2008 (last year, it was 14 months). In other words, investors are now roughly turning over their entire portfolio on an annual basis. When you consider that the two fundamental components of real equity returns are the dividend yield and real earnings growth, you quickly realize that the current level of trading activity is impossible to justify in terms of economic fundamentals. Or, as Jack Bogle, Vanguard's straight-talking founder, puts it:
Investors who don't understand what investing is all about think it's reflected in the stock market, but, in the long run, investing has nothing to do with the stock market. The stock market generates no returns, it subtracts from the returns earned by our corporations. Investing is owning businesses [that] earn a return on their capital, pay you something out in dividends and reinvest the remainder in building a better company.
The siren song of the market
Direct access to exchanges and other market centers combined with low-cost trading is a siren song for individual investors. Those who will ultimately reap the benefit of lower costs need the common sense to recognize where their advantage lies -- with long-term, fundamental investing over short-term trading -- and the discipline not to get caught up in the frenzied gambling the stock market promotes. That's easier said than done, for, as Aaron Brown, one of the foremost "quants" and risk managers, points out, the stock market is structured as a casino, rather than a venue to promote investment and effective capital allocation:
There's no reason the exchange couldn't accumulate all buy and sell orders for the day and execute them all at one price at 4 p.m., the way mutual funds do. ... All the intraday trading is day traders making negative-sum bets with each other. Serious long-term investors would be perfectly happy to buy or sell once per day, and probably even less frequently in most cases.
Lower costs are a happy result of the transformation of our trading markets. Long-term investors can and should take full take advantage of this. On the flip side, however, investors need to be increasingly mindful of the risk of brief, but significant market dislocations such as the flash crash of May 2010. Even long-term investors need to do some buying and selling on occasion. The following recommendations constitute best practices in order to minimize the execution risk of these operations:
Prefer limit orders to market orders
A market order is an order to buy or sell a stock at the best price prevailing in the market. It does not specify a price. The investor who uses a market order is exposed to the risk that the price at which the order is executed differs from the price that was displayed on their screen at the time that they created the order. High-frequency traders are splicing a second-long interval into ever shorter sub-intervals during which a new trade can take place -- potentially at a different price than the last one. In most cases, any difference between the price you observe and the price you obtain will be small, but in a flash crash scenario, it could be substantial -- certainly enough to render the trade unattractive.
In the wake of the May 2010 Flash Crash, the SEC implemented stock-by-stock circuit breakers that mandate a five-minute trading halt if the stock price moves up or down by more than 10% in a five-minute period. The SEC initially rolled out circuit breakers to all the stocks in the S&P 500, and has since extended the measure to stocks in the Russell 1000 and certain ETFs.
While circuit-breakers reduce the execution risk described above, even a 10% difference between the price at which you expected to transact and your realized price would be a very nasty surprise with a material impact on your expected return. Furthermore, it's important to reiterate that these circuit-breakers do not apply to all stocks, and that stocks that fall outside the program are those where execution risk is highest, like small-cap stocks or foreign stocks with lower liquidity.
You may object that using a limit order over a market order means you can't be sure your order will be executed. In theory, that's true. In practice, however, there is nothing stopping you from setting it at the market's ask price, for example (or even at the bid).
Don't use stop orders
A stop order is an order to buy or sell a stock once the price reaches a specified value ("stop value"). Investors enter sell stop orders at a price below the current market price in order to limit a loss or protect an existing, unrealized profit.
Stop-loss orders will reduce your volatility: If the stop is triggered, the order to close your position is triggered and, once executed, you are no longer subject to the market's gyrations. In the wake of the flash crash and other such phenomena, investors may be tempted to think this is an increasingly attractive option. That would be a mistake.
Stop-loss orders are no miracle solution -- they do reduce your volatility, but they do so at a cost. As evidenced in the 2008 paper "Re-Examining the Hidden Costs of the Stop-Loss," by Wilson Ma et al., for assets with a positive expected return (those are the ones we want to own!), using stop-loss orders reduces your expected return. Simulating the use of stop-loss orders on an asset with the same historical return and volatility characteristics as the Dow Jones Industrial Average, they conclude that "setting a 1% stop-loss actually decreases the probability of getting a positive 8% return. This stems from an opportunity cost of missing out on market recoveries where the stop price is breached and the asset price subsequently recovers." Note that this result holds regardless of the level at which the stop-loss is set.
Investors who use stop orders are those who fear volatility because they don't have a notion of intrinsic value independent of price on which to tether their investment decision-making. Instead, they look only to the stock price for cues on how to behave. In reality, that isn't the attitude of an investor at all, but that of a trader. Rather than enabling investors to dominate volatility, stop orders place them and their investment results squarely at its mercy.
If a flash crash does occur
It's my belief that flash crashes will become increasingly frequent. At the very least, the events of May 2010 are not a one-off -- in fact, smaller-scale crashes, restricted to a few securities, have already occurred in equity and other markets since then.
If this does occur and you witness spikes in volatility or stock price gaps that do not appear related to any fundamental (business-related, as opposed to purely trading-related) news, here are few considerations to keep in mind:
- If it affects stocks you own, you must resist the urge to act rashly. Do not sell stocks you own solely in response to an unexplained price decline. That may be an adequate response for a trader -- someone whose actions are driven by price movements -- but for a fundamental-oriented investor, it's equivalent to switching sports mid-competition. Your first priority is to determine whether there is a fundamental reason for the price decline. If there is, you may want to revisit your thesis for the stock and your estimate of intrinsic value. This takes time and is a prerequisite to any action. If there is no discernible fundamental cause, you need not be concerned.
- If it affects stocks in which you have open orders, you are protected if you followed the advice above and entered a limit order. If the order is executed, you will receive the limit price or better. Do not re-enter an order unless you are certain the initial one has been cancelled.
- If it affects stocks that you were considering buying, you're probably best off just ignoring it (assuming you even catch wind of it in the first place). Why? While in theory it could be an opportunity to take advantage of a market dislocation to buy shares at a price that you believe is attractive, you'd want to confirm that there is no fundamental cause behind the decline first. In many cases, I'd expect that investigative process to take longer than the duration of any flash crash, if that's what is turns out to be, so prices would have stabilized by the time you're ready to act. If the decline is persistent, you'll have the time to reformulate your opinion of the stock and decide whether or not you are still interested in buying it. If you ultimately decide to follow through, you should use a limit order.
Follow these recommendations and you'll be able to sail through the next temporary market dislocation with the same breezy attitude Jack Bogle recommended a few days after Knight Capital's
