Guest Post Author Bio: This blog post was written by Tony Chou. Tony Chou teaches readers how to invest in the financial markets. He gives out different scenarios, and then explains how to invest in those scenarios, such as How to Invest in a Panic.
Investors should have learned this from the stock market crash in 2008, that there is a major flow in the modern stock markets. That flaw lies in computer algorithms and trading.
Computer trading is where an investor generates a computer model to determine what stocks to buy or sell. The investor simply enters all the data and prices of the stocks into the computer model, and the computer will tell him or her what to buy or sell. The major problem lies in how these models are created.
Like all other computer models, investment algorithms are based from taking past data, calculating it, quantifying it, and creating the investment algorithm. To understand the problems in computer trading, you don’t need to understand too much about how they work. But what you do need to know is that there are millions of traders and investors depending on their investment algorithms to tell them what stocks to buy or sell.
Now let’s go backwards in time. What caused the 2007-2009 financial crises to be so severe? My answer: computer trading. All those millions of investment algorithms deployed by traders ended up all pretty much recommending to buy the same stocks, and to sell the same stocks. So it ended up being that the algorithms were all pretty much alike, and that all those millions of computer investors with billions (if not trillions) of dollars all ended up owning or shorting the same stocks.
Then, in 2007, markets started stalling. All you need is one big push for the damn to break. Once a few of those computer algorithms generated sell signals, all the other computer algorithms also generated the same sell signals. So what they had in their hands was millions of investors all trying to get out of the markets at the same time. And you know what happened? Liquidity dried up. So you have millions of computer traders trying to get out of the markets, and meanwhile there’s not much market liquidity left. And we all know what happens. Everything went south from there on end.
My point is, computer trading causes often illogical amounts of volatility, and can easily destroy the stability of the modern day financial system. Take the past few days for example. We had intraday fluctuations of up to 5% each day. That kind of volatility means only one thing: millions of computer algorithms are generating the same buy and sell signals. It’s like a herd of animals going back and forth between the bulls and the bears. In times of crazy, irrational market volatility like this, it’s best to stay away from the markets. It’s too easy for both the longs and the shorts to get washed out.
So, what have you learned about the stock market and it’s influence? Are you changing your investment strategy?