“The average investor has no hope of knowing, of course, even the little he needs to know.”
This week, Michael Lewis, author of Moneyball, Liar’s Poker, and many other books about business and Wall Street, released Flash Boys: A Wall Street Revolt documenting the rise of high frequency trading (HFT) and how HFT creates a net cost for everyone else who invests in the stock market.
It has already generated buzz in the financial community, including spurring the Securities and Exchange Commission to initiate an investigation into HFT practices.
On its surface, HFT is insidious, but also legal. It has, according to the book, created a tax on the total investment assets of people who invest in the U.S. markets – at least in the ways practiced in Lewis’s book. It is also perfectly legal, just as sheltering assets from taxes through trusts is perfectly legal. Naturally, there are arguments that one is more morally clean than the other, but neither is illegal if done correctly.
Upon reading the headlines, investors will question the validity of the marketplace, wonder if they’re being taken advantage of, and cry for changes. Some of them will also pull their money out of the markets for fear that they’re getting chopped off at the knees.
In this article, I shall argue that the most action you should take is to request that your local Congressman or Senator investigate for breaches of fiduciary duty of the brokerages involved and to amend or change the regulations to account for the actual state of affairs (though, personally, I have no doubt that the market is smarter than the lawmaker and will find ways around any regulation that appears), but that you personally shouldn’t be changing your market investments as a result of HFT.
High Frequency Trading and You
When you place an order to purchase an individual stock, you generally have two options for making that purchase. You can purchase the stock at the market price, which means that you’re willing to pay whatever people are willing to sell the stock for, or you can purchase the stock at a limit price, meaning that you’re not willing to pay more than a certain amount to get that stock.
Stocks are listed with two prices: bid and ask. The bid price means the highest amount that buyers are willing to pay for that stock, and the ask price means the lowest amount that sellers are willing to take for that stock. In actively traded stocks, the difference between the bid and the ask price is minimal, and in lightly traded stocks, the difference can be significant. When you place an order, the broker is supposed to get you the best available price for the stock, and uses multiple exchanges where stocks are bought and sold to get you that price.
It is easy to think that in today’s age of high speed Internet services, you, sitting at your computer, can know what the price in the market is, and while watching CNBC, you can be as quick as the pros in executing trades.
The reality is much, much different, and it has to do with speeds that are fractions of the amount of time that it takes you to blink your eye.
As Lewis explains, high frequency traders have access to Internet cables that are simply faster than everyone else’s to reach exchanges. Therefore, when a trader puts in an order, a HFT can execute that order, and then zip through to other markets and take advantage of the difference in prices that other exchanges have before those exchanges realize that the first trade happened.
Because of these HFT practices, the average buyer rarely gets the best price (sometimes as low as 17% according to Flash Boys: A Wall Street Revolt), and the HFT firms pocket the difference.
This comes at a cost, ranging from $1 billion a year to $5 billion a year.
The cost of HFT is a drop of water in the ocean
While $5 billion is a huge number and more than any of us will ever see, let’s put it into perspective.
According to the World Bank, in 2012, the total market capitalization of U.S. stocks was about $18.7 trillion dollars.
That’s .02% of the overall market capitalization.
See that little microscopic red sliver? That’s the HFT “tax.”
If you bought $1,000 worth of stocks, that’s 26.8 cents.
Yes, it’s an outrage that such practices are allowed and are legal, but the reality is that, as an average investor, it’s not going to make or break your ability to retire.
HFT mainly affected large lot orders that institutional investors make. They’re making those investments on behalf of lots of ordinary people like you and me, so, indirectly, we’re being hurt and the practice of this milking should be addressed; however, we’re not being so badly hurt that we’re going to wind up as cat food connoisseurs and dumpster diving when we’re in our 90s.
How did this happen?
A lot of it involves dark pools – closed exchanges where brokerages put retail investors (funds and ordinary investors) and their orders into competition with HFTs who paid for access and their own proprietary trading arms. So, rather than executing at the best price, as their fiduciary duty required them to do, they profited. Read the book to get a better understanding of dark pools and how these brokerages were using them to help the proprietary trading arms rather than their own customers, and then, if so moved, you can write your Congressman or Senator asking for action against the potential violation of fiduciary duty (if it happened at all).
Does this mean you should do something different?
It’s my opinion that you shouldn’t be investing in individual stocks in the first place. As we discussed in “The Stock Market is Irrational; Does This Mean You Can Take Advantage of It?”, you’re highly unlikely to be in a position where you can take advantage of mispricing, and even then, you can’t account for herd behavior and investor psychology. Furthermore, as we discussed in “Do You Have to be Lucky to Beat the Market,” it can take between 25 and 60 years to determine whether or not you’re a skillful trader or simply lucky. Unless you’re a whiz at networks and software optimization and have the capital to relocate to a server farm in a direct networked route to an exchange, you can’t beat these guys at the trading game.
There are better ways to try to make your gains:
- Have a plan and stick to it. This is the most powerful weapon you have in your arsenal. Rather than flitting to and fro based on any given headline, losing a little bit on each activity, make a plan and stick to it. If you can save enough, then eking out an extra .1% return won’t matter in the long run.
- Look at entrepreneurship. As we covered in “Why My Alpha Bias is Towards Entrepreneurship,” your best chance of hitting a home run comes via entrepreneurship. It’s how I hit mine. While there are no guarantees, you can certainly control many more factors than you can by trying to play the markets.
- Look at real estate. It’s not for everyone, particularly given that it’s impossible to have more landlords than renters, but for those who are in a strong financial position, it can be the foundation for a PIRE strategy.
- Don’t obsess over headlines and fret over Wall Street. Put into perspective against what is important in your life, this should barely register a blip, if it registers at all. If you finish reading this article, shrug your shoulders, and say “so what?” then you’re doing just fine. There are many more important things to worry about in life. Focus on what you can control.
What do you think about HFT? Did you think anything before this? Do you want to read the book? Are you taking no action – a bad thing, but doesn’t affect your life? Let’s talk about it in the comments below!