High-frequency stock trading — the markets where sophisticated algorithms running on bleeding edge hardware trade assets using information only fractions of a second old — is under attack from Senator Chuck Schumer. In response, The Business Insider has republished a detailed piece explaining why Schumer’s criticism is unfounded.
Readers interested in the full details of the debate should take a look at that piece; this short post will simply clear the air around one concern. ArsTechnica described what many are probably thinking:
The real issue is that when the average retail investor gets an E*Trade account and tries to play the stock market, she typically has no idea that she’s going up against the market equivalent of IBM’s chess grandmaster-thumping supercomputer, Deep Blue.
That’s true, and it should be frightening. Most of us have no business betting against those odds. But if that sounds unfair, we should remember that it’s not the only game in town.
As far as we little people are concerned, we can divide investments into two big categories. Let’s call them “growing the pie” and “cutting the pie.” If we think of the stock market as a pumpkin pie, growing the pie means spreading your money throughout the whole dish, hoping that it gets bigger. Cutting the pie, on the other hand, is like trying to guess which slices of the pie will grow faster than others and putting your money only in those slices.
In practical terms, growing the pie could mean investing in an index fund. These funds invest in stocks according to broad public indices, like the S&P 500. That index rises and falls along with the whole economy, and because the economy grows reliably over time, the index fund does too. With the S&P 500, investors can expect long-term average growth around 8-10% per year, and anyone can piggyback off that growth essentially for free.
Cutting the pie, on the other hand, means trying to do better than average. This describes investors who pick stocks, like day traders or i-bankers. Unlike growing the pie, cutting it is a zero-sum game. For every investor who beats the averages, another falls short. It’s in this kind of trading that people are competing against computers, and the computers are only getting better.
Personal investors really have nothing to worry about, though, because they shouldn’t be playing that game in the first place. Trying to beat professionals at their own sport–literally competing with investment bankers for the same dollar–is always going to be a losing proposition. The only prudent approach is to invest in the whole pie, let other people spend their time on the pieces, and just sit back and watch it grow.
Of course, some people will always want to gamble against the odds, and that’s a risk they’re allowed to take. But if we try to “level the playing field” for them by banning the superefficient trading that goes on in high-frequency markets, we’ll end up slowing down the pie for everyone else.