Is computerized trading discouraging human investors?

Concerns about the rise of so-called algorithmic trading are usually centered on its reckless speed and potential unpredictability. But the biggest problem with robo-trading may actually stem from its efficacy, not its flaws.
Written by John Herrman, Contributor

Science fiction authors and tech industry observers alike tend to frame man's relationship with machines in the same way: computer intelligence is a boon, until it becomes impossible to control.

This is the thread that runs through the work of Asimov and Dick, as well as some of the most significant tech narratives in the media during the last 20 years. Most recently, this kind of thinking spawned a series of fascinating pieces in both theNew York Times and Wired about the rise of computerized trading.

In particular, these pieces zoomed in on high-speed algorithmic trading, and played on fear; of loss of control, and of unintelligent, unaware computers spiraling into disaster. From Andrew Nusca's coverage here on SmartPlanet:

The... problem is that safety measures to prevent pile-on volatility must be put in place as rapidly as this infrastructure is being built, to prevent “flash crashes” like the one that occurred in May.

He then poses an alarming question: "[A]re we really getting smarter, or are we playing with the financial equivalent of nuclear weapons--more powerful than imagination, but catastrophically destructive when out of control?"

It's an important question, but one that will likely be answered for us, rather than by us, as the inexorable computerization of financial trading continues. Whether the process is smooth or full of blunders, it's going to continue.

But if we are to take the rise of algorithmic trading and computerized news parsing as an inevitability, we should start asking bigger questions. Like, does it render individual trading futile?

That might sound alarmist, so I'll back up a bit. Here's a relevant clip from Wired's piece on algorithmic trading, concerning a new Dow Jones service called Lexicon:

[Lexicon] scans every Dow Jones story in real time, looking for textual clues that might indicate how investors should feel about a stock. It then sends that information in machine-readable form to its algorithmic subscribers, which can parse it further, using the resulting data to inform their own investing decisions. Lexicon has helped automate the process of reading the news, drawing insight from it, and using that information to buy or sell a stock. The machines aren’t there just to crunch numbers anymore; they’re now making the decisions.

Once refined, this technology could--could--cut a broad swath through the financial services industry, raking aside the thousands of trained professionals whose jobs are to parse financial news and find actionable intelligence. In reality, this transition will probably be slow and partial, but there's little doubt that its influence of computer news parsing will be felt.

Where the impact could be even more sever, though, is outside of the financial services industry. These computers aren't just responding to tiny fluctuations in markets anymore, or executing complicated trades on behalf of their clients (a word that carries multiple meanings here). They're performing the most basic duties of anyone who trades stocks. They're deciding, based on news and publicly available data, whether or not a company is a good investment, in the same way that an individual handling his own retirement fund might do. Any investor is now competing directly with computers.

Felix Salmon, one of the authors of the Wired piece, later took to his blog to address this concern:

[T]here are millions of individual investors doing diligent homework on companies and trying to invest intelligently in the stock market. When they finally arrive at a conclusion and the time comes to buy or sell, their collective decisions are known politely as “retail order flow,” and less politely as “dumb money”; high-frequency trading shops make lots of money by paying for the privilege of filling those orders and taking the opposite side of those trades...

It’s possible that one individual investor...can beat the odds and make more money on his own than he would do simply investing in an index fund. If he does, then it might be due to luck, and it might be due to skill...Fundamentals-based investing is (still) a very crowded trade, and most people who try it fail—they get picked off by faster, smarter, more sophisticated players in the market.

This kind of straightforward, "is this company healthy?" type of investing is already difficult for individual investors to pull off, given how few resources for information they have at their disposal as compared to an entity like Goldman Sachs, or even a much smaller investment firm. I suspect that most individual investors understand and admit this, albeit with the belief that their little slice of "dumb money" is slightly smarter than everyone else's.

But it's one thing to accept that you're investing against larger, smarter, and generally more effective organizations; it's another to know that your your stock bets are being responded to--and potentially used as grist--by unthinking computers.

It's easy to convince yourself that you're smarter than the other guy. Believing that you're going to out-trade a bank of supercomputers, though, takes a lot more nerve.

This post was originally published on Smartplanet.com

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