Algorithms vs retail investors (fundamentals-based investors can't beat High Frequency Traders)

Reuters ^ | 01/11/2011

[SeekAndFind]

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.

[DManA]

Not sure how much high frequency noise affects the normal investor, as opposed to the normal speculator.

[Yo-Yo]

Time was, this sort of high frequency trading would have any profits swamped by broker fees.

[OhhTee5]

I see the question as an apple and oranges question.

High frequency traders use a completely different approach and technique then an individual investor. There’s no real way to compare them or their results.

But, I do believe an individual investor can hold up very well, despite having the high frequency traders in the mix.

It’s my opinion the key to successful investing is to first establish a “process”, a set of rules you invest by, and stick to those rules.

Then you have a starting point to see what works and what doesn’t, and you can then continue to fine tune your rules in order to improve the process.

I feel the product (investment) is pretty irrelevent, it’s the process that’s critical.

A simple example is when someone decides to go someplace...that’s the process. Wheather you use a car, walk, train or bus, etc (the product), will determine the efficiency of your process, but all modes of transportation may get you to your destination.

In investing, once you decide to invest and the structure of your investing technique (the process), then you can decide which product to use to fit your process.

Another example, suppose you decide to invest in technology. You can select from individual companies, mutual funds, ETF’s, options, etc, all of which will give you exposure to your desire of investing in technology. Which product you choose will be determined by your individual process.

A simple process, might be to divide your investment dollars into even pots. If you have $50,000 to invest for example, you might consider working with ten $5,000 pots. This gives you ten opportunities to succeed, rather then put all of your available funds into 1 or 2 investments.

Another part of your process may be to establish a rule that addresses “averaging down”, and when to apply it.

For example, if you allocate $5K to a technology investment and it goes down, you could have a rule that when it’s 10% or more down, to buy more of it, so when technology does go up, your investment has less to go before you are profitable.

Once you’ve established some rules, I’d suggest you back test them by using past charts and/or values of particular investments and see how you would have done.

This will allow you to check your process, before you invest any funds.

Hope this is of interest. Good luck all.