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Yoshikami: Protecting Against High-Frequency Traders

Tuesday, 11 May 2010 | 11:26 AM ET

The autopsy continues on what caused a 1000 point drop in the Dow last Thursday. It's no wonder investors are concerned; can Accenture really lose 99% of its market cap in 10 minutes?

But with a quick look at the chart, it is obvious to the naked eye that electronic trading was at least partially to blame for the tailspin.

Panic can't happen THAT fast without the aid of computers!

What we saw seemed to indicate that the spike down was due to a significantly huge flow of orders routed between varying exchanges that caused disequilibrium between buyers and sellers. In other words, there were more shares for sale than there were buyers and the auction nature of the market punished investors.

It’s unlikely that you are one of the investors who placed those bets in a blink of an eye.

CNBC.com

That prize goes to traders with supercomputers.

It’s all about speed, and we are not talking about seconds, but trades made in a matter of microseconds (one-millionth of a second).

Using supercomputers to capture market variances trading firms seek to capture small variances in everything from stocks to currencies to commodities.

This so-called high frequency trading result in bursts of trades which can be highly destabilizing. It has drawn the attention of regulators and members of Congress due to concerns that it doesn’t allow investors to operate on a level playing field.

Such a relief I’m sure for you; yet again rules are considered after the damage is done. Little comfort to investors in companies like Brown & Brown Inc. which lost half of its value in the blink of an eye.

We all know that speed isn’t necessary the best asset of regulators. So what should investors do to protect themselves from these high-frequency traders before the regulators catch up with the impact that technology advancement has on the investment community?

First: Be careful and vigilant about the instructions you give to your broker when you place your trades. Be specific about your buy and sell calls; selling at any price can lead to highly unattractive execution price. You should always be aware of the circumstances at which your investments can be sold. There is likely to be little recourse for those investors who had sold at punished prices last week when the market took the plunge.

Second: If you plan to take a gamble on speed and play the fast trading game, remember there is always someone, some trading firm out there, with a better computer and a better trading system than you. In fact, they probably have many computers and many mathematical geniuses adjusting algorithms everyday. Trying to beat these quant folks at their own game can be a monumental task. Resources matter and believe me, these firms have resources.

Third: If you plan to invest your money, you have to remember the basics.

Understand your investment time horizon and your definition of success for your investments.

Always keep an eye on your assets and monitor them regularly, invest on the longer-term horizon if you can.

Make adjustments as needed, and try not to panic when markets swing. But adjust as needed.

True this won’t insulate you from the swings we saw last week, but a healthy dose of perspective on your time horizon will help you resist the temptation to panic. Having the right perspective that the research you conducted showed Procter and Gamble was a stable company is reassuring when confronted with irrational plunges in PG’s stock price (like last Thursday!).

Before you say that it's foolish to endure market losses, let's be clear that I'm not advocating putting your head in the sand. Remember that in this environment having your head in the sand leaves you open to being run over by a runaway truck without you even knowing. I am simply saying that the longer your time horizon, the better your odds that your thesis will play out. A well thought out strategy can be comforting when markets panic and collide.

Fourth: Don't think for a second that any investment decision you make does not require a second, or third occasional assessment. Your decisions should be subject to frequent reviews and adjustments.

The world is changing rapidly and you must adjust to current conditions; maybe not at the speed of supercomputers, but enough to avoid irrelevance. It may be a while before regulators do their part to rein in these high-frequency traders and limit their overwhelming impact on the markets. But in the meantime, invest on the assumption that volatility is here to stay. Be proactive and have a plan to survive and thrive in today’s rapidly changing world.

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Michael A. Yoshikami, Ph.D., CFP®, is Founder, President, and Chief Investment Strategist of YCMNET Advisors, Inc., a registered investment advisory firm (www.ycmnet.com). He oversees all investment and research activities of YCMNET. He is a respected lecturer speaking frequently on market issues, tactical asset allocation, and investment strategy. Michael and YCMNET were ranked as one of the top 100 investment advisors in the United States for 2009 by Barrons. He appears regularly on CNBC and CNBC Asia and can be reached directly at m@ycmnet.com.

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