At neighborhood barbecues and family gatherings, I’ve been hearing more and more talk that the stock market is rigged. In particular, high frequency traders are manipulating stock prices, making it impossible for anyone not working on Wall Street to make any money.
Proponents of this view point to the Flash Crash in 2010 as evidence. If you’ll recall, at 9:30 a.m. on May 6 of that year, while the broad market averages were fairly quiet, 150 stocks traded up to 20 times their normal volume, with many falling 10 percent or more in a matter of seconds before quickly stabilizing.
Just last week, the market experienced a mini Flash Crash when a technical glitch nearly sunk Knight Capital Group, a high-frequency trading firm.
Many ordinary investors feel the game is stacked against them. They’d rather earn next to nothing in a money market account than lose their life savings in the equivalent of a poker game where the other players keep pulling aces out of their sleeves.
So, are my friends and neighbors correct? Is the market rigged against the little guy? Well, yes, but not in the way that you think.
First, do high-frequency traders and other Wall Street creatures – hedge funds, private equity, etc. – influence the market marginally over very short periods of time? Probably, but so what. Unless you’re a day trader, the gyrations caused by high frequency traders don’t matter. What matters over the long run is corporate earnings and even Wall Street isn’t powerful enough to manipulate that.
True investors have a time horizon of years – if not decades – not minutes. Over that length of time, high frequency traders become more like sports broadcasters. They make a lot of noise but have no influence on the outcome of the game.
No, it’s the not the flashy high frequency traders or hedge fund managers that pose a danger to small investors. In fact, the real threats lie low, quietly eating away at your returns like termites destroying your house from within. Nobody notices them until it’s too late.
The biggest threat to your investment returns is simply costs. How much are you paying your mutual funds each year? The average stock mutual fund charges 1.5% a year. The average stock index fund charges around 0.2% annually. (An index fund is a mutual fund that simply owns a part of the market, such as the S&P, rather than trying to buy and sell stocks to beat the performance of that part of the market.)
Of course, the extra costs of the stock mutual funds would be worth it if they outperformed the index funds (the stock market) by the difference in their fees – 1.3%. Unfortunately, stock mutual funds don’t do any better than the market, meaning small investors could have saved themselves 1.3% a year by just investing in index funds.
Doesn’t sound like much, does it? Well, that 1.3% advantage can add up over time. Over 20 years, a $100,000 earning 9% a year grows to $560,000, while that same $100,000 growing at 1.3% a year less increases to only $440,000, 21% less.
Another big cost is commissions. Most small investors pay around a 5% commission to their sales person – oops, sorry, investment advisor – every time they buy a stock or mutual fund. There goes another 5% of the portfolio. Between the commissions and the annual mutual fund fees, your eventual nest egg is reduced by 26%.
And people worry about high frequency traders. They’re about as dangerous as a declawed hamster.
Of course, we shouldn’t blame everything on Wall Street. Small investors are quite capable of sabotaging their own investment returns, thank you very much. Indeed, they seem to have a knack for timing when to get into and out of the stock market – except that they get into the market near its top and get out near its bottom.
Thankfully, we have an easy way to avoid the threats posed by Wall Street and ourselves. A low cost, tax-efficient, globally diversified portfolio that takes the right amount of risk for your situation guarantees that your portfolio captures as much return as the market offers without jeopardizing your long-term plans.
Of course, you need to stick to the plan and that’s where a good investment advisor comes in. An investment advisor shouldn’t just put together a good investment plan; he or she should sit down and explain why they’re employing a particular strategy and using specific tools (mutual funds or bonds) to implement that strategy. Because, let’s face it, if someone doesn’t understand the plan – even a very good plan – they likely won’t stick with it when times get tough.
In the end, a solid investment plan isn’t flashy, but it works.
Mark on Money 