Don't Fret About Those 'Flash Boys,' Cautious Investors

Timothy McCarthy
April 22, 2014

At the onset, I want to applaud the efforts of Michael Lewis, author of "Flash Boys," a recently published book on high-frequency trading, and Brad Katsuyama, president and CEO of the IEX exchange, as well as the institutions and regulators working to expose problems with trading in our country. Those firms and individuals using technology to "front run" investors' orders as they are entered into the system must be stopped if our markets are to be considered fair for investors.

Cautious investors need not overreact to recent headlines by not investing in the stock and bond markets. There are two reasons why investors should continue to maintain a balanced portfolio that includes stocks and bonds:

The cautious investor knows that frequent trading generally leads to underperformance over the long run. They select funds, both active as well as index, and exchange-traded funds run by reputable fund companies that practice a buy and hold strategy in order to capture the long-term growth of markets, decrease portfolio volatility and keep transaction costs for their investors to a minimum. Typically, such funds have a low turnover ratio, often greater than one to two years, meaning that the managers are only infrequently selling. The same goes for those investors managing their own stock portfolios. A buy-and-hold strategy, at least for your core investment portfolio is the safe and cost-effective approach to long-term investment growth. This strategy results in keeping your overall trading costs de minimis relative to your overall performance.

As I mention in my new book, "The Safe Investor," it is important to look at the total cost of trading, buying and selling public securities, in the context of history as well as the cost of buying and selling most other products in today's economy.

All-in costs of equity trading have dropped significantly and consistently each decade since May Day, 1975, when negotiated commissions were first instituted. In the 1970s and 1980s, the spreads between the bid and offer of a typical stock often could exceed 5 percent of the total stock price. Plus, to trade even 500 shares of a stock could cost you $100 or more. Today, spreads are routinely less than 1 percent of the total cost of each stock. And commissions, especially for institutional block orders, are often less than 2 cents to 4 cents per share, even from the brokerage firms that provide research. And, if you trade retail via a discount broker, your net price is not much more than if you were a giant institution.

Secondly, it is worthwhile to compare the total cost of a stock transaction to what you pay in commission and or buy/sell spread to buying and selling any other equivalent asset: a house, or a car or a work of art. Although some of these transaction costs have also declined, you can quickly see that overall, the cost of trading a security is not a bad deal for consumers. It is certainly not a reason to stay out of equities.

Sure, there are implicit trading costs that are not apparent to the average investor. The concept of "implementation shortfall," first articulated by Professor Andre Perold in his 1998 paper, "The Implementation Shortfall: Paper vs. Reality" in the Journal of Portfolio Management, made it possible for us to accurately assess what the full cost of a transaction really is. Simply put, if you want to buy a stock, you look at the price on the screen. Then put in an order immediately and ask yourself, "What is the actual price you ultimately pay, including all transactions costs?" The difference between the price you decided to buy at the moment, and what you actually paid in the end, represents the implicit portion of cost to acquiring that stock.

Of course, markets can be volatile, but over time you can get an accurate sense for what it costs you to trade, implicitly and explicitly. Even with traders finding innovative ways to take their cut, this total cost of a trade has declined considerably over the last two decades. Despite the cheating that has been accurately exposed by the recent works of Lewis, Katsuyama and others, today, investors are still looking at an average total cost of often less than 1 percent. Of course, for large block orders, their size can cause the price to fluctuate dramatically and open the door for traders to look for a way to manipulate the market. But that is what retail investors, via their management fees, pay their investment managers to stay on top of. The combination of market enhancements instituted by regulators such as the Securities and Exchange Commission Order Handling Rules, decimalization and many other safeguards has shrunk the profitability per trade for Wall Street insiders considerably, and ultimately for the benefit of investors.

For the average investor, who should not be trading his or her portfolio actively anyway, one should not be afraid of maintaining a good balance of equities in one's overall portfolio of investments.

Make no mistake, for the good of markets and society, we do need to understand and better control high-frequency trading and penalize those who aim to cheat the system. It is important to ensure investors have confidence in the system if they are to continue to thrive. Equally important, the level of high-frequency trading that is now present in markets can exacerbate volatility dramatically especially in times of financial crisis. Nothing will scare investors more than dramatic swings in prices and thus, the structure to ensure that all orders can get to the markets in a fair and orderly way is best cure for unstable markets.

Tim McCarthy is the author of "The Safe Investor," released in February 2014, and former chairman and CEO of Nikko Asset Management Co. He has also worked at other large financial institutions such as Fidelity Investments and Merrill Lynch.



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