Why does the share market just ‘lose it’?

Andrew Zbik

Andrew Zbik

The first week of February saw shares markets around the world capitulate with the Australian market down 4.8%, US Dow Jones was down 7%, European markets were down 6.9% and Asia followed trend down 5.3%.

Why? Surely if markets react like this something bad is happening. It’s time media outlets started showing the real reaction of traders when a market has a fit like we saw over the last week. I’m not talking about the faces of worried middle-aged men on some trading floor in the USA. The tweet below is the most honest example of traders reacting to last week’s share market rout.

Yes. That’s right. Computers are the real reason behind last week’s sudden down movement in share markets. Most trading in shares domestically and internationally is now done via computers using two methods call ‘high frequency trading’ and ‘algorithmic trading’.

Essentially, software programs are written to identify trends in share price movements and the software will automatically place trades to buy or sell shares. At certain points in time the trend will change and these automated software programs can overreact resulting in the sudden downward movement we saw over the last week.

The below two charts show what an impact computerised trading has had on stock markets in the USA (accurate and up-to-date data is a little harder to find for Australia). As you can see, high frequency trading now makes up around half of all the trades in the USA alone.

The second chart shows how this impact on the market is a relatively new phenomena which came into prominence in 2008. Now, there would be no coincidence with this and the GFC right? One thing is clear, the presence of computer driven trading is here to stay.



In fact, JP Morgan last year said they estimate only 10% of trading volume is now done by stock pickers. This fact I believe is why we are now seeing so many active managers (i.e. Stock pickers) underperforming the market over the long-term.

The below table from Standard & Poors shows the shocking trend that many of these actively managed funds are underperforming the general market over the long-term.
The one exception is mid-to-small cap managers (essentially fund manager in Australia who are not investing in the top 200-300 companies measured in market capitalisation).



So, how do retail investors like you and me compete against computers? We can’t. That is why I advocate an indexed approach for my clients. We recommend using Exchange Traded Funds or indexed funds which are a basket of directly owned shares based on an index.

For example, the iShares Core S&P/ASX 200 Exchange Traded Fund (ASX ticker code: IOZ) will invest in the top 200 companies listed on the Australian Securities Exchange based on market capitalisation. The management fee is a very competitive 0.15% and your investment is going to perform largely in line with the overall market.

After reading the above it may sound a little gloomy that computers are controlling the world share markets. They are! So what do we mere mortals do when we cannot compete with the nano-second decision making ability of a piece of computer hardware and software?

Here are two strategies that I am recommending to my clients to deal with computers calling the shots.

1. How to start investing for the first time?

For first time investors we discuss what the desired size of their investment portfolio will be. We then recommend that they make an initial investment of 50% of their available funds into the market. The remaining 50% we invest in equal monthly instalments over the following six-to-twelve month period. This approach will prevent you from throwing all of your hard earning savings into the market to only find the value of your investment is down 5%-10% a few months in. Not a nice feeling for any first time investor.
By investing the balance in small monthly instalments over a period of time this enables you to purchase more of the investments at a potentially lower price. This will average our your investment into the share market thus helping to gain positive returns potentially sooner as opposed to needing to wait for the value of your investments to recover if you got the timing wrong.

2. How to manage and existing share portfolio going forward?

For investors who already have an existing share portfolio, we are recommending that they commit to a regular investment plan by making monthly contributions to their portfolio to be invested. We are not recommending that clients invest all surplus cash each month into their portfolio. Say maybe half of the amount of any free cash savings. This again will slowly build a portfolio over time taking advantage of any dips like the type we have just seen.

At the end of the day, investing is a long-term activity. I always recommend that clients invest for a minimum of five years.

By Andrew Zbik, Senior Financial Planner



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