Competing with cyborgs: How computerized trading is destroying retirement accounts
By Jason Lampa MBA
Alternative Investment Store
What I have found to be most disturbing is that many of the investment advisors with whom I speak are not even aware of computerized trading programs, still under the impression that their asset allocation models based on the tenants of Modern Portfolio Theory are minimizing risk and maximizing return for their clients.
"Portrait of a losing side, proof positive that you can't outpunch machinery. Proof also of something else: that no matter what the future brings, man's capacity to rise to the occasion will remain unaltered. His potential for tenacity and optimism continues, as always, to outfight, outpoint and outlive any and all changes made by his society, for which three cheers and a unanimous decision rendered from the Twilight Zone." — Rod Sterling
It is easy to draw comparisons between this classic episode and what investment advisors and their clients face when investing in the 2012 stock market. The advent of computertized high-frequency trading has turned a stock market once based on the economic merits of individual companies, into a wasteland dominated by cyborgs controlled by mathematical algorithms.
Financial institutions, whose asset base far exceeds that of the retail investor, unleash their trading programs into the market, buying and selling large quanities of stocks instantaneously. Their goal is to make a couple of pennies on each trade, which leads to handsome profits. In such a market, what are the probabilities of my 93-year old grandmother, who has been sold the mantra "buy good companies with solid dividends for the long term," generating a return on her investment?
Like the aformentioned "Twilight Zone" episode, in which boxing between human fighters is banned, I believe that individual investors should be banned from investing in the stock market until the cyborgs are eliminated.
What I have found to be most disturbing is that many of the investment advisors with whom I speak are not even aware of computerized trading programs, still under the impression that their asset allocation models based on the tenants of modern portfolio theory are minimizing risk and maximizing return for their clients.
In years past, I used to gently persuade advisors to rethink their philosophy. After 2008, my capacity for such ignorance has vanished. Let's take a look at two recent examples of how computerized trading has led to the destruction of retirement assets for retail investors:
May 2010 — The Dow Jones intraday average dropped 9.2 percent, erasing more than $1 trillion of market value. Financial media outlets suggest that many investors recovered from this trading error; however, if you speak with investment managers on the front lines, you'll hear a much different story
August 2012 — Knight Capital sends numerous erroneous orders in NYSE-listed securities, resulting in a pre-tax loss of $442 million. My favorite piece of commentary on this event came from a press release which stated that clients were not affected by the erroneous trades. How about the shareholders of Knight Capital, which is publically traded? Sometimes, I feel as though I am in the Twilight Zone when reputable news outlets exhibit such a high level of ignorance.
These events have led some to demands that the regulatory agencies place controls on how financial institutions can use computerized training. Moreover, those in the media are calling for severe penalties to be levied against firms such as Knight Capital, whose software creates erroneous trades. Great idea in theory, but impossible in the real world.
Why do you think the SEC will make four visits to one registered investment advisor with $30 million in AUM within a span of nine months, warning him about the dangers of alternative investents, but large institutions who trade against their own clients do not get a visit for two years?
The answer is simple: Those working for the SEC understand that the real money is made in the private sector. It is not beneficial to ruffle the feathers of potential future employers. The SEC nor any other regulatory authority will do what is in the best interest of individual investors until it begins affecting the votes received by politicians.
The other answer, though I can not imagine such integrity still exists, is that the financial institutions will agree to refrain from computerized training, similar to what occured when nuclear weapons were disarmed across the globe.
I have always believed that objection without solution is a useless exercise. In an effort to get out in front of those investment advisors surely thinking of ways to tarnish my credibility at this point, I recommend five alternatives in which you can allocate your client assets without feeding their lifelong earnings to the cyborgs:
1. Liquidity (savings account) — Somewhere in the history of money management, the idea that liquid investments are superior to illquid investments took over once rational minds. In addition to computerized trading destroying retirement accounts, the decision was made to allow individual investors to manage their 401(k) account. This opened up the door to an entire generation depleting their accounts via loans and withdrawals. If you have a client who desires liquidity, create a savings account bucket in which those assets are not placed in investments.
2. Income — If you spend enough time listening to retirement income "experts", you will begin hearing that 4 percent is the sweet spot in terms of income that retirees can afford to take off their nest egg. This is followed up with, " Our models tell us that anything more than 4 percent will lead to retirees running out of money. Unfortunately, many investment advisors (not all) are so concerned about the fee they receive on assets under management that they decide to pay their clients a 4 percent dividend rather than take the time to find investment opportunities that will be beneficial for all parties.
For those serious about becoming the advisor of choice during the distribution phase, partner with real estate experts in particular markets who understand the importance of the rent/home value ratio. Hint: Take a look at Jacksonville, FL.
Instead of having 10 clients invest $100,000 in a bond index ETF, have a lawyer in your network create a limited partnership in which your clients purchase a foreclosed apartment building close to a university. The probability that your client will receive more than 4 percent annual income is high. Yes, I know this takes more time than placing them in a passive investment strategy in which you're charging a 1 percent management fee, but consider the amount of referrals you'll receive from such efforts.
3. Capital appreciation — In the coming months, you are going to see numerous articles discrediting crowdfunding. The USA Today already attempted to write a one-sided article portraying crowdfunding as the next invesment scam. Where once investing in private companies was only available to 1 percent of the population, in the coming months, 1 percent will turn into 100 percent, once crowdfunding is officially made legal.
Recommending private market opportunities to your clients will not only differentiate your practice, but will show that investment professionals still possess something missing from this industry during the past decade or so: courage.
As an industry, we're in a tough spot. We can continue to accept the cyborgs eating away the retirement savings of investors, or we can work together to make the stock market a place in which investors like my 93-year-old grandmother, who believe in purchasing stocks based on the merits of their financials and dividend growth, have a fighting chance.