Is the Stock Market Rigged?

This question has been asked ad nauseam over the last week after author Michael Lewis made such a proclamation during his recent “60 Minutes” interview. Lewis, author of “Flash Boys: A Wall Street Revolt” (W. W. Norton & Co., 2014), alleges that high-frequency traders are seeing what trades are being placed and are jumping in line ahead of those investors who placed the trades and profiting at the expense of everyone else.

This has set off a firestorm of debate, including this spirited “discussion” between Brad Katsuyana of IEX Group, a hero in Lewis’ book, and Bill O’Brien, the president of exchange operator Bats Global Markets Inc., which was founded by a high-frequency trader. Adding fuel to the fire is Charles Schwab calling high-frequency trading “a growing cancer.” Even without all the controversy swirling about this week, high-frequency trading (HFT) has already had its share of bad press over the last couple of years. In March, New York Attorney General Eric Schneiderman said he’s scrutinizing practices that give some computerized firms a speed edge. And agents from the Federal Bureau of Investigation (FBI) are investigating whether high-frequency trading firms break U.S. laws by acting on nonpublic information to gain an edge.

Even some CI readers are asking whether it’s even worth the time and effort to try and compete against the big boys on Wall Street.

The answer, in my humble opinion, is a resounding “YES!” Does that mean I don’t think the markets are rigged? That I can’t say. People much smarter than myself can’t say with certainty whether HFT benefits the market by increasing liquidity and lowering costs. Ever since technology and investing and have together, there have been those with a technological edge. HFT is basically day trading on steroids, where automated, quantitative trading systems are scalping razor-thin margins on trades in mass, mass quantities. For individual investors, I always viewed day trading as a losing proposition, because it was virtually impossible to track the number of securities, and execute the volume of trades, to make the endeavor profitable.

So what do I say to those individual investors who are throwing up their hands in frustration? Don’t try to take on the Wall Street powerhouses on their field of battle. In my opinion, if you are an individual investor who mainly invests in the bluest of the Blue Chips, let’s say the S&P 1500, you are probably best served by investing in an index fund. The costs are lower and as an individual investor there is no way for you to out-analyze or out-trade the professionals.

As an individual investor, your greatest advantage is being able to compete in arenas where the big players can’t set foot. Many pension funds, mutual funds and other institutional investors have restrictions on what they can and cannot invest in. It only makes sense for high-frequency traders to focus on the stocks with the greatest liquidity, which is generated by institutional investors. Individual investors don’t face those restrictions, which offers opportunities for the patient and vigilant investor willing to do where the big money can’t. A perfect example of this is the AAII Model Shadow Stock Portfolio. Over the last five years, its average annual gain has been 44.5%, net of transaction costs.

So, in closing, don’t let splashy headlines and talk of no-win situations keep you out of the market. Stocks are the surest way to financial success, assuming you follow a disciplined and reasoned approach.

 

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  1. Good post, but I think you miss the damage done by HFT. As you say, ” HFT is basically day trading on steroids, where automated, quantitative trading systems are scalping razor-thin margins on trades in mass, mass quantities.” The $1 billion that HFT makes every year comes out of the market. If the HFT operations did not take that money, it would be profit for the other investors including, especially, the ETFs. HFT profits are a tax on all of the other people in the market.

    • Playing devil’s advocate, how are the profits made by HFT any different than the profits generated by Warren Buffett? Buffett gets sweetheart investment deals that you or I would never be party to because of the amount of capital he brings to bear, as well as his name. If it was 100% certain that there was something nefarious behind HFT, you would be absolutely correct. But that has yet to be determined.