Sunday, May 23, 2010

How Liquidity Can Be Bad for Investors

It is axiomatic among finance professionals that liquid investments are preferred for individual investors, especially those that aren't wealthy. It's easier to buy and sell liquid stocks and bonds. Information about them is easier to get. They tend to have readily ascertainable values.

But these qualities, especially the ease of buying and selling, make liquid investments the focus of computerized trading. Computers can observe prices, and buy or sell stocks, all in milliseconds. Their great speed allows them to profit from holding stocks for just a moment. It's not unusual for a computerized trading system to complete a purchase and sale of a stock in ten seconds or less.

All this frenzied computerized activity requires highly liquid markets. The program has to be able to trade quickly at or very near, the prices the computer observes. Otherwise, the algorithm (i.e., the mathematical formula) on which the program is based won't work well, and, horror of horrors, money could be lost.

So the banks, hedge funds and other institutional investors deploying computer-driven trading strategies have come to dominate the markets for the most liquid investments. Over half the trading in the stock markets today is computer-driven. The small investor, who thoughtfully researches investments before timorously buying a couple hundred shares, is playing on an interstate filled with tractor trailers. For little apparent reason other than a deluge of lickety split orders spewed out by immensely powerful computer systems, investors can lose 10% or more in a matter of minutes. This happened during the flash crash on May 6, 2010. It could happen again.

The markets for the most liquid of stocks and bonds are beginning to look like commodities markets, where positions are bought and sold for momentary profit, and where the big, powerful traders garner almost all the profits. The Model T version of investing--buying and holding--is taking on a distinct resemblance to the Tin Lizzy.

The stock markets have always favored the big firms and large investors. Small investors (a/k/a chumps) have always been at a disadvantage. But there once was, or at least seemed to be, something in it for Mom and Pop. Today, however, the stock market, unadjusted for inflation, is trading about where it stood in April 1999. That's 11 years ago. Factor in inflation, and we're back to mid-1997, 13 years ago. Either way, that's a long time with no gains. The Moms and Pops who put faith in CDs and money markets came out ahead.

Individual investors have largely stayed out of the most recent bull market. The last few weeks' volatility will only reinforce their skittishness. They know that, should they ever get the urge to go back into stocks, they'll never beat a computer to the punch. Why put your hard-earned savings into a market where you're behind the competition and have no hope of catching up?

High tech traders argue that computerized trading adds liquidity to the market and therefore is beneficial. They overlook that fact that long term buy and hold investors (so-called "natural" investors in market parlance) are the true fount of liquidity. Drive them out, and the market, and we, will be poorer for it.

No comments: