Algorithms vs retail investors

January 10, 2011
article I wrote in Wired with Jon Stokes, emails with a couple of questions:

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Anand Iyer, after reading the article I wrote in Wired with Jon Stokes, emails with a couple of questions:

The age of analysing a company’s stats, looking at its balance sheets, researching the market the company operates in, and looking at the people running the company seems to be gone. It’s all bots (highly sophisticated ones) who operate the financial world.

What I wanted to ask was would it make sense for a single person to be doing investing the good old fashioned way in this scenario (I do and I guess I will even if your answer tends to suggest in the negative, but I would be VERY interested in your answer).

Finally it would be very helpful if you were to recommend me some books on this algorithmic approach of investing and advise if it is indeed possible for one individual to do the very same thing.

My answer, I fear, won’t make Mr Iyer very happy.

Firstly, there are millions of individual investors doing diligent homework on companies and trying to invest intelligently in the stock market. When they finally arrive at a conclusion and the time comes to buy or sell, their collective decisions are known politely as “retail order flow,” and less politely as “dumb money”; high-frequency trading shops make lots of money by paying for the privilege of filling those orders and taking the opposite side of those trades.

It’s possible that one individual investor—Mr Iyer himself, perhaps—can beat the odds and make more money on his own than he would do simply investing in an index fund. If he does, then it might be due to luck, and it might be due to skill. But if I know nothing about Mr Iyer except for the fact that he’s a retail investor looking at corporate fundamentals, I wouldn’t give him much of a chance of beating the market. Fundamentals-based investing is (still) a very crowded trade, and most people who try it fail—they get picked off by faster, smarter, more sophisticated players in the market.

On the other hand, fundamentals-based investing is vastly more sensible than an individual investor even thinking about entering the shark-infested waters of high-frequency algorithmic trading. You can’t do it, don’t even try. If you do give it a go with real money, expect to lose all that money, very quickly.

The good news is that for the time being it’s not even possible for individual investors to enter this market: the barriers to entry are just too high. But if it ever does become possible, stay very far away. Unless you want to know what it feels like to lose years worth of savings in a matter of hours.


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