Man vs Machine

Man vs. Machine: A Battle Best Avoided

Man vs Machine

A question we are often asked at Index Funds Advisors is whether the individual investor stands a chance against the high-frequency traders that now dominate the financial markets. Our answer, of course, is no, but that does not mean dismissing the whole thing as a rigged game and thus staying out of the market entirely. In a chess analogy drawn by Professor Terrance Odean of UC Berkeley, "individuals [traders] are no longer playing against Grandmasters; they're playing against Deep Blue; they will almost certainly lose." The power of the computers to analyze enormous amounts of data continues to grow exponentially, while the human brain is pretty much stuck where it is. As Mark Hulbert points out in a recent article on MarketWatch, it is not just amateur traders who are losing to the supercomputers but the professional "advisers" (i.e., newsletter publishers) as well. Of the 51 advisers out of more than 200 on the Hulbert Financial Digest's list who beat the market in the ten years ending April 30, 2012, only 11 (22% of the 50 or 6% of the 200) have outperformed the market in the one-year period since then. The lack of persistence in performance indicates the very large role played by luck.

So what should an individual investor do? According to Hulbert (and we would concur), the answer is simple: Don't trade - just buy and hold low-cost index funds. While you may not beat the market, it is likely that you will beat the majority of traders who think they can beat the market but instead get trounced by the supercomputers. For the few times that an index fund investor does trade, the liquidity provided by the high-frequency traders can help keep trading costs in check. The crucial point to remember is to refrain from trying to beat them at the game where they have a significant advantage.