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Sep 03 2013

Why ordinary investors always lose out in the stock market

I do not directly invest in the stock market. I do not have the knowledge to do so nor sufficient interest to invest the time to study how it works to make the kinds of informed decisions that are required. Of course, my retirement money is invested by others on my behalf but that goes on automatically without any involvement on my part. I have no idea what is going on.

But any slight inclination on my part of become an active investor was further dampened by this report by Rob Curran that says that in these days of high speed trading, those with access to information that is even a fraction of a second before others get to know it can make a killing at the expense of the rest of us.

Terrence Hendershott, a professor at the Haas business school at the University of California at Berkeley, wanted to find out. He was recently given access to high-speed trading technology by tech firm Redline Trading Solutions. His test exposes the power of latency arbitrage the way Ben Mezrich’s Bringing Down the House exposed the power of card counting.

According to his study, in one day (May 9), playing one stock (Apple (AAPL)), Hendershott walked away with almost $377,000 in theoretical profits by picking off quotes on various exchanges that were fractions of a second out of date. Extrapolate that number to reflect the thousands of stocks trading electronically in the U.S., and it’s clear that high-frequency traders are making billions of dollars a year on a simple quirk in the electronic stock market.

One way or another, that money is coming out of your retirement account. Think of it like the old movie The Sting. High-speed traders already know who has won the horse race when your mutual fund manager lays his bet. You’re guaranteed to come out a loser. You’re losing in small increments, but every mickle makes a muckle — especially in a tough market.

“It’s clear to us these guys are just raping, pillaging, and plundering the market,” as Joe Saluzzi, co-founder of agency brokerage Themis Trading put it.

In this day and age where we think of ‘instantaneous’ global communications, we need to be reminded that the limit imposed by the speed of light actually plays a tangible role in everyday life. Those brokerage houses that are physically closer to the exchange have an advantage because the electronic signals carrying the information get there a fraction of a second before the more distant places. Brokerage houses are moving closer and laying dedicated high-speed cable lines just to gain a few fractional seconds.

This is another case where technology has outpaced a legacy system. Although there are ways to counter this defect, the stock exchanges have not taken steps to adjust. I cannot tell whether this is due to institutional inertia or willful neglect because the system is run by and for the insiders. But being the cynic that I am that the world is rigged to favor the oligarchy at the expense of the rest of us, I suspect the latter.

11 comments

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  1. 1
    Tabby Lavalamp

    Just another reason why I firmly believe that while the stock market is a good idea in theory, in practice it’s one of the worse things to afflict modern civilization.

  2. 2
    machintelligence

    Since this strategy works on micro moves in the stock price, it could be eliminated by equally putting equally microscopic trading costs on all such trades. I am sure that this tiny “tax” on rapid trading would be strongly resisted by Wall Street, but it would affect the individual and institutional traders like mutual funds almost not at all. It would also have the beneficial effect of reducing rapid fluctuations caused by the trading programs.

  3. 3
    unbound

    Yep. Stock market favors 2 major types of players:

    1) Corporate senior executives – who are just handed stock shares and stock options. It doesn’t matter what the market does at any given time as long as the stock doesn’t nose-dive into oblivion, free stock sold at anything is big profit.

    2) Existing rich – who just hire the smart people to make the money for them.

    For everyone else, there is Mastercard (debt).

  4. 4
    Reginald Selkirk

    Another approach to ending this would be to require that once purchased, stocks be held for a certain amount of time.

  5. 5
    Rob Grigjanis

    Physicists are to blame!

    http://www.theguardian.com/science/2013/jul/21/physics-graduates-gravitate-to-finance

    I particularly liked this comment;

    I’ve long had my suspicions that physicists were quantum tunneling into my life savings accounts. Now I know it’s a fact.

  6. 6
    Trebuchet

    I’ve often said that the difference between Wall Street and Las Vegas is that there are far fewer crooks in Vegas, those that are there are smaller scale, and the games in Vegas are far less likely to be rigged.

  7. 7
    Glenn

    For a good science fiction look at computer trading I suggest reading ” The Fear Index” by Robert Harris. Like Jurassic Park, it has enough non-fiction possibilities to engage imagination in light of the trillion dollar financial devastations the past few years have provided.

    It’s a good monster story that will be made into a movie next year

  8. 8
    Gregory in Seattle

    Until the 1980s, the stock market was a very good investment practice: you bought stock in a solid company, held it for many years, and collected dividends (a share of the company’s profits, thus “share” of stock.) Owning shares make you a part owner, and when the company did well, you did well too. You had the option of either reinvesting the dividends to buy more stock (usually done by younger people) or keeping the money as income (usually done by older people.) When you needed extra money, you sold your shares, usually after several decades of reinvesting.

    In the 1980s, however, the market came to be dominated by speculators, who bought stocks they figured would go up in value with the intent of selling them quickly for profit. They didn’t care about how profitable the company was or what its long-term prospects were: as long as the market value of the shares went up, they were happy. This get-rich-quick scheme made so much money for everyone that blue chip corporations started phasing out dividend-paying shares, which carried certain legal obligations, for shares that did not pay dividends. In 1986, the tax rate for capital gains (profit made by selling stock) was lowered to match the tax rate for dividends (usually used as retirement income), and dividend shared largely disappeared. In January of this year, the tax rate on dividends was increased, nominally from 15% to 18.5% but possibly as high as 48.3% thanks to how the sequester was written.

    Unfortunately, with the prime interest rate so excruciatingly low, savings accounts and federal bonds are not a feasible option: savings accounts are paying around 0.5% APR, series E/EE savings bonds are earning around 0.2% APR, and parking cash in a money market will probably get you a negative return (i.e., you are losing money, not making it.) This pretty much forces people to invest in mutual funds, which offer decent returns but have a lot of fees, which go into the pockets of the mutual fund managers and holding companies. This is exactly what both the Republicans and Democrats want.

  9. 9
    Emory K.

    Physicists should vigorously endorse high-speed trading. The problem with those dedicated data lines is that they have to follow the curvature of the earth. Maximum trading speed can only be achieved by taking a shortcut through the earth. That requires neutrino beams. And neutrino beams mean great employment opportunities for physicists.

    Of course I’m being facetious here – Nobody would seriously propose neutrino beams for high-speed trading, and therefore Dr. Singham is not being traitor to the physicist class.

    Nope, nobody would ever propose that:

    http://www.forbes.com/sites/brucedorminey/2012/04/30/neutrinos-to-give-high-frequency-traders-the-millisecond-edge/

  10. 10
    Dunc

    So who’s on the other end of these high-frequency trades? If it’s all just computers buying and selling with each other, then surely the aggregate long-term effect on market valuations should be pretty much a wash?

  11. 11
    Mano Singham

    As I understand it, us ordinary people we are on the other end of the trades. If the insiders know a stock price is going up in a few milliseconds, they can buy it a a lower price and then sell it at the higher one a short while later. They make a profit while we take a loss since we got a lower price than we might otherwise have got.

    But take my analysis with a great deal of caution since I am a novice on the stock market.

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