Tuesday, July 07, 2009

Man v. Machine: The stock market

A few things have come to light since the accusation that one of Goldman Sachs’ programmers stole some of their quant platform’s code. One of the more interesting quotes from that Bloomberg article:

“The bank has raised the possibility that there is a danger that somebody who knew how to use this program could use it to manipulate markets in unfair ways,”

This is what the Assistant U.S. Attorney had to say about the alleged theft.

Now, this sentence has raised a lot of eyebrows. I first read about the story on Zero Hedge. Most recently, ZH had a guest post about the topic reiterating how bizarre it is for Goldman to point out that this program allows for market manipulation, and what that means exactly. Mainly, it’s you, the retail investor, who is being scammed by programs like this:

Markets are a zero sum game - somebody wins and somebody loses. Where do you think these “many millions of dollars” are coming from? They are coming from you - the average retail investor and the large institutional investor. These programs are taking advantage of real order flow and are siphoning off small profits throughout the day that belong in the pockets of the retail investor and the traditional money manager.

I thought I’d bring up some of my personal experience as a retail investor in that light.

I’ve long known I’ve been trading against computers, especially when trading lower volume stocks and options. Options bid/ask pricing is done way too quickly and “accurately” (in quotes because accuracy is according to Black-Scholes, the equation responsible for putting Long Term Capital Management out of business) to be a human. Or, if it is a human, they’re aided by a computer that’s constantly changing bid/ask prices for them. Here’s what I have to say about it:

If you are making a real investment, you shouldn’t care whether you’re trading against a computer or a human.

Notice lately how everyone (CNBC, e.g.) says that “buy and hold is dead”? The people who believe this (I am one of them – I’ll get to that in a minute) and still believe in the stock market are playing straight into the hands of quants. Why do you think they have everyone and their cousin on CNBC spouting this mantra (“buy and hold is dead”)? The more you trade, the more you’re trading with computers who can reprice faster than you.

But if you do find a real investment you believe in – a precious metal, a stock, a bond, whatever – then you shouldn’t care if you’re trading against a computer. The computer is looking at past performance and current pricing only – a computer can’t judge whether a product coming out in a year is going to be a monster hit. So the only people who really lose against the computer are speculators, or people who are not doing enough research and are getting swept up in bubbles. And while it’s true that most of us are speculators in the true sense of the word (without issuing more stock, a company isn’t gaining anything from my purchase of their stock from another stockholder), a belief, long term, that a company is improving their product, service, process and purchasing their stock can be considered “investment” in spirit.

Hard to believe I just defended quants given all of the damage they’ve done to our economy and investors, but there you go.

Oh, and about "buy and hold." I do believe it's dead right now because most stocks still seem priced too high. The only thing I am newly holding long at the moment is cash, because it seems like the best hedge against deflation.

No comments: