Is high-frequency trading harming investors?

June 2, 2014

Recently an acquaintance used the cocktail party venue to ask about how high-frequency trading might affect her. She had recently retired, rolling her company 401(K) over to a self-directed IRA with the help of an online financial advice firm. These firms have more than 11 billion under advisement. The few I’ve looked at do a pretty fair job for the computer-savvy investor, especially those who don’t meet the minimum amount of assets for brokers to handle.

Before getting into the academics of HFT, I asked about her portfolio construction and trading activity. Turns out, unlike many self-investors who purchase those outdated investment newsletters, my friend’s investment decisions are largely driven by what she hears on the TV business channel interviews. She tells me she is such a fan she often painfully postpones pit stops to hear.

Making investment decisions based on that source to me means she is a market timing investor in training, something virtually all academic studies consistently discount as a bad idea (except those rare cases when you actually get lucky).

Short answer to her question; HFT would have little actual effect unless she is an active trader. However, that might not be the only problem. What is a problem is thinking you can outdraw the professional gunslinger. HFT is all about timing, and the other guy is always going to be faster.

The stock market is viewed by many, me included, as a trip to the casino. HFT uses ultra-high-speed computers to analyze all types of market data and trends, then trades on that information. HFT is faster than a speeding bullet, at over 1/10,000 of a second and increasing. Investment firms spend millions trying to gain a millisecond advantage over the other guy. Remember it takes two to tango; for every buyer there must be a seller.

There will always be someone who can decimate information and trade ahead of the other guy. For my friend, jumping up from the TV and making a trade simply puts her somewhere in the pack.

HFT firms are under some pressure from federal regulators possibly spawned by the Michael Lewis book “Flash Boys,” which suggests the market is rigged against the retail investor. Duh! The feds are concerned that something illegal is going on, possibly involving "front running,” where advance information, or seeing the price of a stock from one exchange is used to beat the other guy on a different exchange.

For example, take a stock priced at $20. A big seller moves the price down to $19 on one exchange. The HFT system sees this and buys at $19.99 and sells at $20 on another exchange before the market price officially changes. This may not affect my friend significantly with a 100-share purchase, but trading millions, even billions of shares can account for jamongus profits in the case of a mutual fund or institutional investor.

The feds need to figure out how to neutralize this advantage in some way, because in addition to the unfairness to all investors, these complex systems can inflict serious pain when they hiccup, as evidenced by the May 2013 Flash Crash event.

So the speed of the trade isn’t the only problem. It’s that common mistake of betting against the house and thinking you can consistently win. My advice: avoid the herd mentality and stay focused on the long term. When you hear or read about something, it’s old news. It’s OK to occasionally buy on a whim, but it's a gamble, so don’t bet the farm.

John Boraski is a Registered Investment Advisor.