LISTEN: VOLATILITY UP, INVESTORS OUT (mp3audio) (4:54 min)
Here’s the lead sentence from a July 19, 2010 report on the stock market from BTN Research:
The S&P 500 stock index fell 2.9% last Friday 7/16/10
Losing almost 3% of value in one day is a pretty big decline; for investors, July 16, 2010 was not a good day. However, it is worth noting that the July 16, 2010 decline had been preceded by eight consecutive days of gains – in the language of investors, July 16 was a “pullback.” This is the nature of stock markets; they fluctuate.
But recently, the fluctuation, or volatility, has intensified. The BTN report noted that “in the last 50 years, a 1-day gain or loss of at least 2% for the S&P 500 has occurred every 21 trading days. Since the beginning of September 2008 (i.e., the start of the global credit crisis), a gain or loss of at least 2% has occurred every 4 days.”
In other words, for 50 years, sharp one-day changes occurred about once a month. But in the last two years, the steep moves have been happening once a week. Certainly the struggling global economy plays a part in the jumpiness of the markets, but there may be other factors at work.
The Wall Street Journal’s July 12, 2010 front-page story carried this headline:
Small Investors Flee Stocks, Changing Market Dynamics.
Two days later (July 14, 2010) , the WSJ’s “Money & Investing” section led with this title
Letting the Machines Decide
Here’s the connection.
The July 12 article noted that the last three years have seen a steady defection of individual investors from the stock market – people have sold their stocks, liquidated their mutual funds, just cashed out. The principal reasons for leaving the market were losses and volatility. In the past, some individual investors may have been willing to ride out declines in the market, or get out slowly as they saw trends changing, but the recent volatility has been most unsettling. Several interviewees mentioned the “flash crash” of May 6, 2010 as an example of the type of extreme fluctuation that motivated them to leave the market. (In one of the largest one-day drops in history, several US indices plummeted almost 10% in 15 minutes before partially rebounding.)
As individual investors leave the market, large institutional investors exert a greater influence. And more often, institutional investors are relying on sophisticated computer models using artificial intelligence to make their investment decisions. These automated investing programs, controlling large blocks of investments, can potentially trigger strong movements up or down in markets, particularly when all the programs arrive at similar conclusions to buy or sell.
For the techno-geeks, the argument for using a complex algorithm to determine investment decisions is simple: “Human beings aren’t improving,” says Spencer Greenberg, founder of Rebellion Research in the July 14th article. But a side effect of removing the human factor from decision-making is the potential for increased volatility. When the computer model indicates “buy” or “sell,” there are no emotions involved – no caution, no anxiety, no fear. Decisions are made without hesitation. So whatever happens, the results will often be seen quickly.
These trends don’t necessarily preclude individual investors from participating in the stock market. Contrarians – those who believe in selling when everyone’s buying and vice versa – might even see great opportunities in this type of scenario. But just as automation has made other processes move faster, the more machines control investing, the greater the likelihood of spikes – both up and down – in the markets.
Like other changes brought about by increased complexity, the challenge will be how to profitably integrate this development for individual benefit.
