Rage Against the Machines


The fear of machines is common in dystopian science fiction, but it's only been recently mused upon in investment thought. In science fiction, the machines arrive. At first they make life easier for us humans; ultimately they threaten to destroy us.

The world of investing is catching up with the concept. Automation to step up efficiency, profitability, or convenience can have some unforeseen, negative outcomes. High-frequency trading has already made quite a few high-profile, hellacious messes, and the topic is becoming more and more of a headline concern.

High-frequency trading, automated trading, quants, algorithms: That's all code for machine investing that's whittling the human element out of trading stocks. We flesh-and-blood investors should be thinking about the many risks emanating from what surely is considered by many to be a market "innovation" but really is amping up market risk.

A glitch in the Matrix
The recent computerized trading debacle that nearly wiped out market maker Knight Capital Group (NYS: KCG) altogether is the latest reminder that just because machines can do some of the work for humans, it doesn't always mean that they should.

Knight Capital's trading glitch was the result of an error in its programming, and it affected about 140 stocks on the NYSE, whose prices went wacko.

Knight Capital is what is known as a market maker. Back in the old days, actual human beings fulfilled this function, pairing up buy and sell orders. Because actual human beings performed the task, actual human beings could see if bids didn't make sense and things were possibly going wrong somewhere.

Computers, on the other hand, will do any dumb thing their programming and algorithms have designed them to do without a second thought. Glitches and mistakes can obviously be devastating, and computers don't have that awesome human ability to muse, "Hey, wait a second, something doesn't look right here."

This of course leads to events like Knight Capital's glitch as well as the 2010 flash crash, the latter of which was one of the most bizarre events in recent market history. For no reason anyone could determine, the market dropped like a stone and stocks plummeted; some blue chip companies' stock prices even plunged to a penny.

More recently, Apple shareholders might have had a few minutes of mini-heart palpitations after the stock fell prey to a "mini-flash crash" this past March. Even more ironic, BATS Global Markets, a company that offered an alternative stock exchange, had a flash crash of its own, and the BATS IPO was canceled.

The Facebook (NAS: FB) IPO turned into a debacle in myriad ways, including the Nasdaq's own trading glitches, caused by demand overload and malfunctions. Facebook stock stopped trading for about an hour on its first day public, and tons of erroneous trades were made during the confusion.

In another example, The Wall Street Journalcovered an interesting adventure in pattern recognition in July. Apple, IBM, McDonald's (NYS: MCD) , and Coca-Cola (NYS: KO) all traded in tandem in what is known as a "sawtooth pattern." Traders speculated that it was probably a new "time-weighted algorithmic program," or TWAP.

According to one trader quoted by WSJ, "There is no reason for someone looking to make money to continually buy it up and sell it down as they'd lose money. Perhaps an algo left unattended and got off the rails."

Um, yeah, no reason. Stupid computers.

These aren't the droids you're looking for
Automated, high-speed trading is a danger to our marketplace for many reasons. One that's been discussed a lot recently is that it easily degrades real, flesh-and-blood investors' trust in their investments. Being at the mercy of machines that are automatically trading and frequently doing so without any rhyme or reason is a pretty good reason to feel insecure.

Personally, I'd include a greater philosophical danger than flash crashes: Doesn't the dehumanization of investing result in the de-emphasis of stock ownership and the importance of business quality?

Our marketplace's foundations are already weakened by many traders' short-term, highly speculative view on investing. Of course, a day trader is to a computer what a human being is to The Terminator. Many of us long-term investors may consider day trading as irresponsible and counter-productive to a marketplace where stocks have meaning other than short-term price, but that's absolute child's play compared to machines that can execute trades far faster than humans -- encumbered by silly attributes like decision-making skills -- can.

Although high-frequency traders don't reveal their speed, apparently many computerized trades take place within milliseconds.

The SEC plans to look more deeply into high-frequency trading, and those of us who are into long-term investments should say that that's not coming a millisecond too soon.

Machines and algorithms don't care about high-quality leadership, growth potential, employee relations, sustainability, corporate governance policies, or brand. In other words, machines don't care about things that will become apparent over the long haul for companies' well-being and potential.

It's time to reboot and rethink how to invest responsibly; long-term smarts are better than speed, and computerized trading is just one more way our marketplace sinks into dysfunction.

Forget the quants' bites out of Apple at times. If you'd like to read about opportunities and risks facing Apple, click the link to receive your free report on the tech giant, including a full year of updates.

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The article Rage Against the Machines originally appeared on Fool.com.

Alyce Lomax does not own shares of any of the companies mentioned. The Motley Fool owns shares of Apple, Coca-Cola, McDonald's, Facebook, and International Business Machines. Motley Fool newsletter services have recommended buying shares of McDonald's, Facebook, Coca-Cola, and Apple. Motley Fool newsletter services have recommended creating a synthetic long position in International Business Machines. Motley Fool newsletter services have recommended creating a bull call spread position in Apple. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.

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