What Happened to Real Investing?

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A little more than 20 years ago, on the occasion of my bar mitzvah, one of my great aunts gave me a couple of shares of IBM. She gave IBM shares to all the cousins on special occasions and, from what I understand, she had plenty to give. I think she and her husband bought a couple thousand IBM shares in the 1950s and since then it’s split a few dozen times.

Now that’s what I call investing in a company.

I say this because these days it seems like the stock market is less about investing in companies in which you have confidence, and more about making bets or “taking positions” on companies and simply waiting for them to move so you can cash in. Now, there have always been traders that engage in this kind of speculation, but Thursday’s 1,000-point market freefall is an example of how this phenomenon can get out of control.

In case you missed the freefall, on Thursday evidently someone goofed, pressed the billion button instead of the million button on some sort of trade, and as a result the stock market went bananas. The Dow dropped almost 1,000 points in a matter of minutes – which is unprecedented – before quickly regaining most of the ground it lost.

Much of the reason for the drop, apart from human error, is the fact that lots of stock trading is automated. People often set computers to make trades when a stock falls below a certain number, which is usually both profitable and convenient, however in this case lost a lot of people a lot of money. There was a time when one mistaken trade, no matter how big, wouldn’t have had such a far reaching effect, and cause everyone else to sell everything else.

Jim Cramer illustrated the point perfectly on CNBC yesterday at the height of the dip. He and some other guys on CNBC were watching Proctor & Gamble’s (Stock Quote: PG) stock as it dropped 25%. He was incredulous.

“If that stock is there you just go and buy it. It can’t be there! That is not a real price! Just go buy Proctor & Gamble! They reported a decent quarter. Just go buy it.”

And people did. Just seconds after Cramer said this, people started buying P&G and the stock regained almost all of the 25% it had just lost. Why? Because Cramer reassured them that the company had value despite what the numbers said.

Now, a few people made a lot of money in those few seconds because they were able to buy the stock at a deep discount, but the initial drop almost certainly cost many more people a lot more money. These folks told their computers to automatically trade the stock if it fell below a certain number, which they almost certainly did when the stock dropped 25%. Unfortunately, the computers in all likelihood weren’t told to buy it up again when it became clear that the drop was the result of a glitch and the stock was on the way back up. You see, computers are smart, but most of them aren’t that smart (except for you, HAL).

And then there’s high-frequency trading. This refers to lightning fast computer programs that trade huge volumes of stock often. This kind of investing isn’t really investing at all. This is more like counting cards at black jack.

All of these clever mechanisms have been proven to be very profitable, but ultimately they distract us from what the stock market is really all about: People supporting businesses they believe in with their hard-earned dollars. Now, I’m not saying that people don’t do that any more, but according to some estimates, as much as 73% of all equity trading is the result of computerized high-frequency trades.


When’s the last time anyone actually got a stock certificate? (I still have the ones I got from my aunt for my bar mitzvah by the way.) These days more people are into buying gold, some invest in fine wine, others in art and others in real estate. These are all real things.

People who engage in high-frequency trading, on the other hand, often don’t know what they’re buying or when they’re buying it. America could use more people like my great aunt. You can argue that maybe she shouldn’t have held on to IBM for 50 years, but at least she knows what she owns.

 

For more on the human vs. machine debate on Wall Street, check out TheStreet.com.

 

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