Why investors can ignore the mini-flash crash

(MoneyWatch) The Aug. 1 flash-crash caused by a trading glitch at Knight Capital Group (KCG) brought back bad memories of the 2010 flash crash. 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.

Although some wondered if the incident signaled that ordinary investors should give up on the market, the better view is to ignore such crashes and keep moving forward with your investment plan.

As Jason Zweig, the respected Wall Street Journal columnist, pronounced following following the debacle at Knight Capital, "If small investors needed any more reason to be disgusted with the stock market, they got it Wednesday." He added, "Make no mistake: The hearts of many small investors have been broken by the serial setbacks of the past few years." 

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Zweig also questioned whether retail investors would call it quits, quoting novelist and English professor Perry Glasser: "You can think you've achieved your investing goal after years of holding on and then lose everything in five minutes. You could buy and hold a company for 15 years and then have everything you've built up disappear in five minutes. No one can take that kind of risk anymore. There's no such thing as a widows-and-orphans stock anymore."

It's probably true, as Bankrate.com columnist Sheyna Steiner wrote, that with the "proliferation of high-frequency trading programs and the havoc they cause when they go haywire, some people may have the perception that the stock market is out of the league of small investors these days."

Before you jump to such a conclusion, some perspective is in order.

Considerations

First, while high-frequency traders have been the root cause of some sharp market moves and their actions have created havoc at times over very short periods, their actions don't change the fundamental value or long-term pricing of stocks. The actions that caused the two flash crashes were rapidly reversed -- demonstrating how wrong Glasser was. He is also wrong to suggest that the recent market crashes spell the end of "widow-and-orphan" stocks. That's because such an investment never existed. Individual stocks have always been highly risky. A perfect example would be the Pacific Gas and Electric (PCG) bankruptcy in 2001. Other examples include Xerox (XRX), Kodak (EK), Polaroid, and Enron.

Second, high-frequency traders have also provided substantial benefits, with their trading patterns reducing the cost of trading for small traders and patient traders alike.

Third, the types of major market moves that have caused investors concerns aren't exactly new. Recall Black Monday in 1987, when stock markets around the world crashed and shed enormous value in a very short time. The crash began in Hong Kong and spread west to Europe, hitting the U.S. after other markets had already sharply declined. The Dow Jones industrial average fell 22.6 percent in one day! Today that would be the equivalent of it falling almost 3,000 points.

Then as now, most of the blame for that crash fell on what were called program traders, computer-driven trades executed with great speed. It's also worth recalling that while we were hearing the same type of concerns back in the fall of 1987, after the crash, from November 1987 through December 1999, the S&P 500 Index went on to return almost 19 percent a year.

Effects on individuals

Let's now turn our attention to the type of investors Zweig was writing about -- small retail investors. For them, the  problem isn't high-frequency traders. Their real problem is that these investors are playing the game on the wrong ball field. They shouldn't be trading actively. And they shouldn't care about daily, weekly, or monthly changes in prices, let alone intraday changes. That's the realm of speculators, not investors. Plus, watching market swings -- especially losses -- won't only affect you mentally, but physically as well.

Individual investors not only shouldn't be trading regularly, they also shouldn't be investing in individual stocks, as that has more to do with speculating than investing. The reason is that owning individual stocks entails absorbing the idiosyncratic risk of those companies. And markets don't reward you with higher returns for taking risks that can be diversified away.

Prudent investors invest in mutual funds that are low-cost and passively managed (such as index funds). As Warren Buffett notes, doing so virtually guarantees that you will outperform the vast majority of investors, both individual and institutional -- assuming you have the discipline to ignore the noise of the market and the financial media.

The bottom line is that while the kinds of occasional crashes caused by high-frequency traders make for good fodder for the daily press and for politicians, these traders have actually had a significantly positive impact by lowering the cost of trading for prudent, long-term investors.