Computer traders suffer – thankfully

Several times on the blog I have sent up investors who rely upon past performance as their primary guide for investing. The reason is that investing is an activity whose benefits unfold in the future, not the past. So relying upon past data exclusively is spurious. The analogy is to someone who forecasts today’s weather based on what happened to the weather yesterday. That method of forecasting is likely very good, however, it is guaranteed to always miss changes in the weather. Enter a story in today’s Wall Street Journal entitled, “Computer-Trading Models Meet Match.”

I have felt for years that these computer models have increased volatility in the stock markets and have also helped contribute to bubble conditions, both in the dot.com era and the real estate era. Basically the way these firms operate is: if the market is going up then buy, buy, buy. And if the market is going down, sell, sell, sell. This “piling on” investment strategy has accelerated ups and downs in the financial markets. This increased volatility creates enormous distortions in terms of information processing.

You see, what happens is that when the financial markets are volatile investors stop evaluating the actual news of the businesses that make up the financial markets, and instead people focus on the financial markets as separate entities. This leads to a view of the “markets” as a separate Frankenstein-like entity that deserves its own analysis, apart from the underlying components of the market. Yet, the two are the same thing! Think about the nightly news and the way the performance of stock markets is reported. How often have we heard something like, “The Stock Markets were up today as investors were encouraged by the results of the ABCXYZ Corp?” The problem is that the Stock Market is not its own separate beastie, but simply the agglomeration of its individual components. So investors ought not to see the two has being separate.

Unfortunately, all too often the performance of the individual components of the “Market,” are performing much differently than the “Market” itself. In other words, the prices of stock shares ought to track the profit performance of the businesses. Does this make sense? So, in large part, these distortions are caused by rampant computer model trading and that leads to poor decision-making on the part of both professional and non-professional investors alike. Ugh!

So, I am glad that these types of trading firms are doing badly. Hopefully it will shake some of them out of the business of managing money.

Jason