Monday, September 17, 2012

The Computer: Investment Tool Or Time Bomb (1)

WALL STREET SMARTS, THE BLOG, IS NOW WALL STREET SMARTS, THE BOOK.  FULLY EDITED AND REVISED WITH NEW MATERIAL ON AMAZON

In a recent blog, we followed a trading strategy which was attributed to Jesse Livermore, the famous trader of the 1920s.  Back then, Livermore's tools consisted of the telephone and the ticker tape which allowed him to follow the changes in price with the shortest delay.  In today's fast paced trading, most on Wall Street use computers to initiate, follow and close out their trades.  This is the case regardless of the assets being traded, be they stocks, bonds, options, futures, currencies or commodities. 

Many professionals use their computers for more than just tracking their trades.  They also use computer programs to run trades.  At the same time they are buying a stock, some individual investors and traders will instruct their broker or program their computer to sell the stock if the price drops by a preset amount (say 5% of the purchase price).  This instruction is called a stop loss order.  The stop loss order can also be used to lock in a gain.  If the stock has increased in price, the individual may, at any time, set a price below the current market price at which the stock is to be sold, thereby locking in the amount of gain the person is hoping to make without having to constantly monitor the market.  As the price increases, the stop loss order price can be raised.  This is one fairly basic strategy which can be initiated from the individual's computer (or with a phone call to the broker).  On its face, this sounds like a smart, conservative approach to investing and trading.  The individual has quantified and limited any loss, while letting any profits run.  If used on a grand scale, however, unintended consequences can result.

In his book, Irrational Exuberance, Professor Robert J. Shiller recounts the results of the Brady Commission's report on the October 1987 market crash.  The Commission was established by President Ronald Reagan to find out what caused the Dow Jones Average to drop 508 points (22.6%) on October 19, 1987.  The Commission reported the following:

The precipitous market decline of mid-October was "triggered" by specific events: an unexpectedly high merchandise trade deficit which pushed interest rates to new high levels, and proposed tax legislation which led to the collapse of stocks of a number of takeover candidates.  This initial decline ignited mechanical, price-insensitive selling by a number of institutions employing portfolio insurance strategies and a small number of mutual fund groups reacting to redemptions.  The selling by these investors, and the prospect of further selling by them, encouraged a number of aggressive trading-oriented institutions to sell in anticipation of further market declines.  These institutions included, in addition to hedge funds, a small number of pension and endowment funds, money management firms and investment banking houses.  This selling, in turn, stimulated further reactive selling by portfolio insurers and mutual funds. (underline emphasis is mine)

Professor Shiller summarized this as follows:

By "price-insensitive selling" they mean selling that comes in response to a price drop but is insensitive to how low the price goes before the sale is concluded -- selling at any price.  The commission was saying here, most prominently, that the crash was caused by what I have called a feedback loop, with initial price declines influencing more investors to exit the market, thereby creating further price declines.  The Brady Commission was saying, in effect, that the crash of 1987 was a negative bubble.

Portfolio insurance was the marketing term for a computer program which instructed the investors' computers to sell stocks when they had declined by a certain amount, in effect, a stop loss order.  The problem was that many different computers' selling programs kicked in at the same time leading to ever lower prices and repeated sell orders, over and over, in October, 1987.  This appears remarkably similar to the avalanche of margin calls leading to ever lower prices and repeated margin calls, over and over, in October, 1929.  Blind reliance on a computer program to replace human decision making can result in widespread losses for the entire market.  The investment holdings of millions of individual investors were decimated with those of the Wall Street giants relying on portfolio insurance to protect their positions in 1987.

We will look at other computer generated problems in the next blog.

Excerpts from Shiller, Robert J.; Irrational Exuberance, copyright 2000 Robert J. Shiller, published by Princeton University Press, reprinted by permission of Princeton University Press.

Comments are always welcome.


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