‘Central banks have become the insider traders of the currency market, which is a paradigm shift that systematic traders cannot pick up as well as fundamental traders.‘ – Bloomberg News
If you had said 10 years ago that central banks were insider trading, you would have been laughed out of town.
Today everyone knows central banks trade in advance of upcoming policy decisions.
But it’s not just the central banks. The big investment banks play the same game too…
If you don’t believe us, take this story from Bloomberg back in May:
‘Goldman Sachs Group Inc. (GS), which generated about half its revenue from trading last quarter, posted losses from that business on two days in the first three months of 2013, compared with one day a year earlier.‘
If we assume there were 60 trading days in the first quarter, it means Goldman Sachs traders made profits 96.7% of the time.
In the world of trading that’s an unheard of strike rate. Most traders are happy to make profits on just half their trades.
Even if you factor in the large number of traders on Goldman Sachs’ trading desk, the law of averages would still dictate a win rate close to what an individual trader can achieve.
So there’s only one explanation – the big boys have a secret advantage compared to every other investor. But it’s not just insider knowledge. Until recently they’ve had another advantage…
Investing: Humans v Computers
Over the past few years, some folks have made a lot of noise about the influence of computer trading at the big banks and hedge funds. Another name for it is algorithmic or ‘algo’ trading.
Many worried that computers would take over the world. Some feared it would even be the end of investing as we know it.
But now it seems that computers aren’t quite so smart after all. In fact, according to Bloomberg:
‘Currency funds that use computer models for trading decisions made 0.7 percent this year through June, compared with 2.3 percent for those that don’t, the biggest margin since 2008.‘
The article says that computers haven’t yet figured out how to trade unpredictable markets. A good example was the US Federal Reserve’s about-face in May, when many thought it would start raising interest rates.
Human traders traded that move quickly as bond yields soared. It seems the computer (‘algo’) trading programs weren’t quick enough to catch the move.
(We guess we’ll find out soon enough on how many days Goldman Sachs traders and computers made profits during this rocky period.)
Saying that, the fallibility of computers and computer modelling shouldn’t surprise you. One of the big controversies during the 2008 financial meltdown was value at risk models (VaR).
Big traders used VaR to work out the potential loss for a portfolio. They use historical volatility and the expected behaviour of various asset classes in certain conditions – stress testing.
But none of this counted for toffee when financial markets collapsed. Events that the models said were a one-in-a-thousand-year’s possibility happened…and in a big way.
So, what does that tell you? For a start it tells you that even the smartest computer trading system needs a human to get involved when the computer misses something.
That’s why, as fond as we are of new technology and its ability to improve lives and drive down costs, we also know the human element is important.
‘Hands On’ Investing
In truth, as a fundamental analyst, we don’t leave anything to automation.
And as far as we’re aware, there isn’t a single computer model that can identify a revolutionary change before it happens. There certainly isn’t one that can identify a company to benefit from the change.
So when it comes to finding revolutionary investments, we have no problem saying we’re old school. Call it a ‘hands on’ approach if you like.
But just as we prefer a ‘hands on’ approach with our investment research, we prefer to be ‘hands on’ when investing our own money too.
We like to know a human has complete control over our savings and investments. But not just any human. We like to have personal control over each of our investments.
That way, on any given day we can know exactly how much money is in our investment savings account. We know our shares balance. And we know the value of our precious metals.
This is vital. It’s important to know where your money is and what you’re invested in at all times. That means avoiding opaque investments. And most of all, avoid investments where you don’t have complete control.
This is the key to avoiding any nasty surprises during the next financial meltdown (whenever it arrives). Whether the cause of the next meltdown is computer trading or human traders, it’s doesn’t matter.
What matters is that you take charge of your investments today.
From the Port Phillip Publishing Library
Special Report: The Sixth Revolution
Markets and Money: The Absurdity of Australian Property
Money Morning: This Stock Market Rally Hasn’t Run Out of Puff Yet…
Pursuit of Happiness: Save Now to Avoid the Government’s Retirement ‘Labour Camps’
Australian Small-Cap Investigator:
How to Make Big Money from Small-Cap Stocks