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Algorithms Take Over The Market: August 17, 2012

John Gorlow | Aug 17, 2012

$440 Million Trading Error

Two weeks ago, one of Wall Street’s largest market-making and trading firms, relying on a computerized trading program, shook investors’ confidence in the market. Trying to gain an edge on its competitors, seventeen-year-old Knight Capital Group rushed out new trading software that wasn’t ready. Instead of fulfilling customer orders, the software unintentionally generated millions of erroneous trades, causing sudden wild price swings in dozens of stocks. As trading volumes expanded, some Wall Street participants profited from the unusually dramatic price swings triggered by the faulty software. Many retail customers, having no idea what was going on, wound up losing money. Some journalists accused Wall Street insiders of using their trading tactics to rip off small investors: but the opposite, in this case, seems more accurate. The mishap cost Knight $440 million in trading losses and forced them to accept a lifeline to skirt collapse.

In the mind of Dimensional Funds Vice President Weston Wellington, the Knight debacle was a painful reminder of the flash crash in 2010 when the Dow Jones Industrial Average plunged over 700 points in 15 minutes. New York Times columnist Andrew Sorkin blames the present fear to invest on the Knight Capital computer trading fiasco and other incidents such as Facebook’s glitch filled IPO. These technology fueled disasters are creating what he calls a Wall Street “crisis of confidence”.

Some investors fear that computerized trading places them at a disadvantage. However, these concerns should be balanced against the upsides of computerization, namely lower trading costs and more liquid markets. Although it may not work perfectly 100% of the time, the benefits of computerization seem to outweight the risk.

What about the buy-and-hold investor? Wall Street Journal columnist Jason Zweig cited four widely held stocks affected by the Knight trading malfunction. The spread between high and low prices on August 1 ranged from 1.96% (Berkshire Hathaway) to 14.64% (Harley-Davidson). The intraday swing was unusual but the net change for the day was considerably smaller (–1.85%, on average), and smaller still for a diversified S&P 500 strategy (–0.29%). To paraphrase Zweig: it's harder than ever for long-term investors to ignore the trading madness of the market, but ignoring it remains the very essence of what it means to be an investor.

In the words of Vanguard founder John Bogle, “rough as the market seas may be at times, long-term investors must hold stocks because as risky as the market may be, it is still likely to produce better returns than the alternatives. Wise investors won’t try to outsmart the market. They’ll buy index funds for the long-term and diversify."


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