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If You Think Trading is “Rigged,” Don’t Trade.

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If You Think Trading is “Rigged,” Don’t Trade.

Republished from: “Forbes”

How To Beat The Rigged, ‘Flash Boys’ Stock Market

This is not a post-April Fool’s day joke, but it riffs on the furor caused by Michael Lewis’s new book Flash Boys: A Wall Street Revolt.

“How do you beat Wall Street at trading?”

“Don’t trade.”

That’s my advice in a nutshell because it avoids the mostly true, but old news of Lewis’s book. You can’t beat robotic high-frequency trading programs unless you have what the big boys have: High-speed fiber optics lines to exchange servers, precise algorithms and the budget to finance all of the latest software and hardware.

When I heard about high-frequency trading a few years ago, people who were in the business told me how it worked. You get your server as close to the exchange as possible, run your programs and make money in milliseconds. You trade a position and dump it in a blindingly short period of time. I know a young man who made millions from programming this technology and is now retired.

Investment firms loved the idea of HFT because the profits were infinite. You could buy and sell in a flash. You could buy a stock then short it. You could arbitrage by buying other stocks as others went up or down. You could buy what others were buying, take a quick profit, then dump it. The possibilities were infinite and legal.

Regulators haven’t caught up to it, although the FBI, New York state attorney general and other so-called watchdogs are finally sniffing around. It was like found money for the trading firms that made the investment running fiber optic “pipe” from New York to Chicago and various exchange servers.

I first wrote about HFT almost three years ago, so when I heard Michael Lewis talk about it last Friday at a conference in Phoenix, it didn’t shock me in the least. Despite the daunting odds against you in daily trading, you can still make money.

I had been advising my readers to avoid short-term trading altogether. But there’s more to the story, of course, which Lewis tells with exceptional detail and verve. There’s only one problem: Individual investors never had a legal advantage against Wall Street. None of this is remotely new. It’s been backed up by decades of academic research.

Here’s what you need to know:

* Short-term trading is a loser’s game for most individuals. How can you compete against robots and ultra-fast fiber optics? You can’t. So forget about day trading. It’s a sucker’s game; even if you think you have the best information and insights in the world, you are not going to get a fair price. You can’t beat the machines.

* You can’t make money due to transactions costs. You’re paying retail prices for commissions. Even at deep discounts, you don’t make money until you beat the spread and clear your commissions. Brokers love it when people trade because they make money on buys and sells. They don’t care if you make money — they always profit.

* While traders got rapid hard wires to exchanges, we’re hardwired in our brains to believe that we can beat this uber-human system. It’s part of what behavioral economists call “overconfidence bias.” We think we have great odds when the game is stacked against us. It’s irrational.

* We trade too often and at the wrong times. We buy gold or stocks when they’re overpriced and dump them when they’re bargains. There’s a famous study that examined these strategies and found them to be consistent losers. Computers don’t make these mistakes and can even manipulate prices through mega-trades that happen too quickly for humans to perceive. Financial Times columnist Tim Harford explains it nicely in this post.

How to Beat the Robots

Since robotic traders are focused on short-term price movements, shift your focus to long-term trends. If you can afford the risk, stay invested in stocks with a mix of bonds, real estate and inflation-protected bonds to diversify. Here’s a sample portfolio:

Vanguard Total TOT +0.14% World Stock Index ETF (VT), 60%

iShares Lehman Aggregate Bond (AGG), 30%

Vanguard REIT (VNQ), 5%

iShares TIPS Bond (TIP), 5%

A big caution: My long-term strategy doesn’t work if you jump in and out of the market.

A “moderate tactical” rebalanced version of my “Nano” portfolio, which I designed before the 2008 meltdown, has beaten the Vanguard S&P 500 index fund over the past 10 years through March 31, according to MyPlanIQ.com, which monitors my portfolio and calculates returns (I receive no compensation or consideration from this service).

By the way, I invest in every one of the funds above except for the Vanguard world stock index fund, so I’m putting my money where my mouth is.

Invest only as much as you can afford to put at risk. Make sure your stock and bond positions are hedged with vehicles that move in the opposite direction.

Any certified financial planner or registered investment adviser can hedge your portfolio using options or exchange-traded funds. While you probably won’t beat the S&P 500 index on a regular basis with a moderate risk portfolio, you will beat those who think they can outsmart robots in a rigged market.

John Wasik is the author of Keynes’s Way to Wealth: Timeless Investment Lessons from the Great Economist, journalist, speaker and author of 13 other books. He writes and speaks frequently on investor protection issues.


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