Are Investors Being Terrorized by Stock-Trading Robots?


There's an implicit assumption in the media that high-frequency trading is scaring investors out of the stock market. In the wake of the debacle at Knight Capital (NYS: KCG) , the volume on this argument has been cranked up to 11.

In Monday's New York Times article looking at the impact of high frequency trading, Nathaniel Popper showed just how ingrained this belief has become with the drive-by one-liner: "These perils [of high-frequency trading] have been one factor scaring investors away from American stocks."

No further explanation, no numbers, studies, or anything else to back it up. The implication is that it's so obvious that it doesn't need any further fleshing out. Individual investors are scared of high-frequency trading, so they're not investing in stocks. Period.

To be fair to Popper, he does add: "They have also been put off by a market that has delivered almost no returns over the last decade because of asset bubbles and instability in the global economy." But "[t]hey have also" suggests that the high-frequency trading concern and the "almost no returns over the last decade" are somehow on the same level, or same playing field, or even in the same universe.

To say that investors are anywhere near as concerned with high-frequency trading as they are with their historical returns is just plain nuts. No, past performance does not guarantee future results. And, no, basing views of current asset allocation on the trailing performance of a period that included one of the biggest stock bubbles in history does not make sense. But, alas, that's the way all too many investors set their investing views. If investors are abandoning stocks -- which isn't as clear as it seems either -- the reason is far more likely to be lackluster past returns than stock-trading algorithms.

Five better reasons
But it's not just poor past performance that's gotten investors fed up. Here are five more reasons (there are plenty more) that easily outrank high-frequency trading in terms of affecting individual investors:

  1. A generational financial-market meltdown that was driven in large part by ultra-wealthy Wall Streeters that don't appear to have been held accountable.

  2. The entire continent of Europe teetering on financial collapse as major Eurozone countries struggle with massive debt burdens.

  3. The lack of a free ride on Facebook (NAS: FB) stock. Nope, nobody should have expected that, but they did. And they're mad that it didn't work out.

  4. A U.S. legislative body that is split by two sides that would rather flip each other the bird rather than do any collaborative work on legislation.

  5. A 24/7 news media that feels like a failure if it hasn't labeled at least three things a "crisis" in any given 12-hour period.

If somebody conducted an open-ended survey that asked investors why they're concerned about the markets, I'd be surprised if high-frequency trading breached 1%. Make it a multiple-choice survey with just three options and a view of the scary animated GIF that's been making rounds, perhaps it'd get up a slightly higher.

A problem that isn't there?
Of course, all of this assumes that there is this pervasive fear among U.S. investors that's causing them to flee stocks. But it's not entirely clear that that's the case. The Investment Company Institute showed a cumulative $30 billion flowing out of equity mutual funds through the first half of 2012. However, nearly $28 billion flowed into hybrid funds, which are a mix of stocks and bonds.

If we zoom into June, ICI shows $6.3 billion in equity mutual fund outflows, versus just $510 million going into those hybrid funds. Meanwhile though, ETF-focused website Index Universe shows a combined $6.2 billion flowing into U.S. and international-equity ETFs.

For market-watchers that focus only on traditional equity mutual funds, the picture may indeed seem like a stampede out of stocks. A broader view, though, suggests that investors may be reallocating to different products as they find options that are cheaper, more flexible, or just plain better than mutual funds.

Be afraid, be very afraid... or don't
While I'm not sold on the idea that there is a massive exodus out of stocks by individual investors, it's obvious that they're not excited about the asset class. And though I'm skeptical that the source of their angst is high-frequency trading, the fact that they're skittish at all inevitably brings up the classic (cliched?) Buffett quote: "Be fearful when others are greedy, and greedy when others are fearful."

Investors that are looking to get long-term greedy in the face of this fear will definitely want to check out The Motley Fool's latest special report: "The 3 Dow Stocks Dividend Investors Need." To score a free copy of this report, just click here.

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