High-frequency trading and robo-advisors are using algorithms to make investment portfolios free of human bias, fear or greed. The algo-based automation is gradually changing the face of financial advising, and the way trading is taking place in stock exchanges across the world.
Even the smartest of investors can slip up at times and get trapped in the fault lines of their own investment decisions. This invariably happens when the golden rule of harvesting the greenbacks is ignored.
The father of ‘value investing’ British-born American investor and economist, Benjamin Graham, once said, “Buy not on optimism, but on arithmetic”.
One invests on logic and not emotions, is the golden rule of investment. It can be a tough task to remain unbiased to different products of investment and more often than not burn fingers, and money too.
As computing turns faster and better at doing automated tasks, options like high-frequency trading (HFT) and robo-advising are creating options for unbiased investments.
High- Frequency Trading: What it is and who does it
High-frequency trading as a program trading platform uses powerful computers to transact a large number of orders at very fast speeds. It uses complex algorithms to analyse multiple markets and execute orders based on market conditions.
According to data from TABB Group, the international research and consulting firm on capital markets, high-frequency trading comprised of slightly less than half of all equity trading in 2016.
The rise of high-frequency trading has altered the way stocks are traded on stock exchanges by shorting the span of trading from minutes to seconds, to milli seconds, or even micro seconds.
The strategy of high-frequency trading is to buy and sell stocks at the speed of light – almost a hundred transactions per second- and gain from the accumulated profits made during these very large numbers of transactions.
Computer servers fitted with trading algorithms located closers to the exchanges are drivers of high-frequency trade.
The servers of these computers engaged in high-frequency trade reap the advantage of sitting closest to the exchange and receive information on bid or ask price, available bid volume or ask volume, last traded price or last traded size etc. much earlier than the rest of the traders. The location advantage also alerts traders on a news break or an event related to a particular stock quicker than other traders.
High Frequency Trading is mostly the turf of Investment bankers, Hedge Funds, Institutional investors. However, a new breed of individual investors like young computer savvy professionals, math coders, engineers and defence contractors are getting lured by the dazzling high-speed trade in stock markets. In developed markets like US, high-frequency trading occurs across the asset class i.e. equities, bonds, forex-in options and futures as well. Even retail investors are permitted to take exposure to high-frequency trading, unlike more conservative emerging markets like India.
Retail investors in India are not yet allowed to take exposure to high-frequency trading, even though it accounts for one-third of the total volume traded in an exchange. As per Aite Group, the other emerging markets like Russia trade around 36 percent of equities and 40 percent of derivatives through HFT, whereas in Brazil the high-frequency trade is 21 percent in equities and 18 percent in derivatives. In developed markets like the US, HFT is prevalent in 13 stock exchanges and private hubs called a dark pools. As per industry data, there are 40-plus darks pools in the US, which account for around 50 percent of total trading volume.
High-frequency trading is the natural evolution of the securities market and founder and CEO of TABB Group Larry Tabb, says he expects it to eventually replace traditional trading models across the world. Like all other technologies, HFT also has to constantly upgrade the algos and contribute to price discovery for the benefit of all in the market.
Managing financial investments with robo-advisors
Another mathematical wonder in the world of investment is the concept of robo-advisor, which is becoming highly popular with Gen Y.
Robo-advisors are basically algorithm-run tools that provide automated portfolio management with minimal human engagement.
The popular appeal of robo-financing is in the simplicity of the entire process, low cost and trustable algorithms.
The further argument that goes in favour of robo-advisors is that they are more reliable in asset allocation, diversification, rebalancing, etc than bone and flesh financial advisers.
A robo-adviser reckoner comes after one submits data like financial goal, risk appetite, investment duration etc. to the computer algorithm. The data is then analysed by algo, which then suggests a portfolio of ETFs that is seen meeting one’s investment needs.
The algos of robo-advisors can even perform more advanced tasks such as regularly rebalancing one’s investments. However, not all may incline towards choosing the option of robo-financing, particularly when one is not comfortable with the idea of a computer making decisions on hard-earned income.
While the power of machines or mathematical algorithms is transforming the business model in personal financing as well as trading in stock exchanges, and firing up the imagination of Gen Yers in developed as well as emerging market economies, it’s important to remember that the algo of robo-adviser merely allocates the investible money into a portfolio which is expected to grow based on inputs like age, risk profile and investment horizon. The fees are also charged depending on the services offered, but robo-advising firms do not make financial decisions on behalf of its clients. For complex decisions, human advisors are still top dog.