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Has high frequency trading doomed the little guy?

April 11, 2014
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By Andy Tilp, CFP®

Learn more about Andy on NerdWallet’s Ask an Advisor

Michael Lewis has caused quite a stir with his latest book, “Flash Boys,” and attendant interview on “60 Minutes.” Listening to the recent hype, it sounds like the little guy is doomed and doesn’t have a chance. But let’s look beyond the sound bites and news scrolls on the bottom of the screen, and take a look at what this means to the average investor.

The crux of the controversy is high-frequency trading. Basically, HFT is acting as a market maker, matching buyers and sellers of a stock. Computers and algorithms see that an order to sell a stock is placed. The HFT system buys the stock and immediately turns around and sells it to fulfill the order. Their advantage comes from the speed at which they operate. The entire transaction can occur in a few milliseconds. They make their money by adding a penny or less to the cost of each share. When this transaction is repeated millions of times, those fractions of a penny can add up to real money very quickly.

To capture these trades, requires massive computing power and speed. Even the tiniest delay in receiving and processing the data can make a difference.

(Note: There are other HFT trading methods, but the focus here is on this process.)

So the question is, what does this mean to you, the average investor? Unless you are a day trader eking out pennies of profit on your trades, it probably means nothing. While it is an interesting mathematical problem to determine the derivative of the instantaneous rate of change of a stock price, it is not applicable to the long-term growth of your portfolio.

Rather, the average investor should have a diversified portfolio of no-load index mutual funds or low-fee exchange-traded funds and be invested for the long term. This means investing in the fundamental growth of the market, where companies grow and make a real profit. The only trading in a long-term portfolio should be an occasional rebalance so you can take your profit from your winners and buy what investments are on sale.