Friday, May 24, 2013

Munger and Buffett: High-Frequency Trading and the Flash Crash

Charlie Munger recently weighed in on high-frequency trading (HFT) and the flash crash during an interview with CNBC's Becky Quick:

"I think the long term investor is not too much affected by things like the flash crash. That said, I think it is very stupid to allow a system to evolve where half of the trading is a bunch of short term people trying to get information one millionth of a nanosecond ahead of somebody else."

He then added...

"I think it is basically evil and I don't think it should have ever been allowed to reach the size that it did. Why should all of us pay a little group of people to engage in legalized front-running of our orders?"

I understand why the comment on "legalized front-running" might make for a better headline but, at least to me, his comment about the impact of the flash crash on the long term investor is of more interest.

If you've bought shares of a sound business with solid prospects at a discount to value, and intend to own it many years, what does it matter if the market price trades down -- even if substantially -- on any given day or even much longer?

A huge drop matters if the funds are needed in the near-term, but shorter term funds don't belong in equities anyway. Otherwise, it only matters if you react to the near-term move emotionally, try to trade it, or something similar that involves the focus on stock price action.

So the speculator may need to worry about price action but a long-term investor does not.

Warren Buffett recently made a similar point. Things like the flash crash is just noise for a true long-term investor. In this recent interview on CNBC also with Becky Quick, he said this about HFT:

" is not contributing anything to capitalism."

Then later added this about the flash crash:

"The flash crash didn't hurt any investor. I mean, you know— you're sitting there with— with a stock. And, you know, and the next's gone past. The frictional cost in...investing for somebody that does it in a real investing manner are really peanuts. I mean, they're far less than the cost in real estate or farms or all kinds of things. So it's— unless you turn it to your disadvantage by trying to do a lot of trading or something of the sort, it's a very, very inexpensive market to operate in...and all that noise should not bother you at all. Forget it."

So the true long-term investor in shares of a good business isn't adversely impacted even if the temporary paper losses are annoying. In fact, the lower prices in the near or even intermediate term will benefit the long-term investor.
(Since a drop allows more shares to be bought cheap by the long-term oriented owner and the company itself can do the same via buybacks also to the benefit of continuing owners. Somehow, this fact sometimes seems to get lost. )

Now, it certainly matters if how the market is structured and system weaknesses causes instability in such a way that it reduces confidence or leads to reduced investment and economic activity more generally.

Highly volatile or unnecessarily unpredictable markets (whether due to self-inflicted instability/uncertainty -- things like market structure and poor system design among others -- or external shocks) can impact the real economy if severe enough to damage business and consumer confidence.

Lowered investment. Reduced consumption.

That's quite a different but potentially very real problem.

Yet, the long-term investor who buys a quality asset at reasonable valuation in the first place isn't hurt (even if the quoted price might be unpleasant to look at for a while). For productive assets, especially those with durable advantages, intrinsic business value just doesn't change nearly as much as quoted prices might otherwise suggest from time to time.

"I never attempt to make money on the stock market. I buy on the assumption that they could close the market the next day and not reopen it for five years." - Warren Buffett

For a good business (or any productive asset), temporarily reduced prices (i.e. shares bought at a discount to value that temporarily sell for an even bigger discount to value) can be a big advantage depending on the particular circumstances, but at a minimum they should be ignored by the long-term investor.

It's when too high price is paid (plainly expensive or an insufficient margin of safety), the business ends up having less attractive future prospects than initially thought, or intrinsic value is poorly judged that a drop in price becomes a problem.

Permanent capital loss.

There's entirely too much emphasis on near-term price action. It's not a small advantage to, instead, place the emphasis on judging well per share intrinsic value and how -- within a range -- it is likely to change over time.

Overconfidence destroys returns. Yet, when justifiably confident in real business value per share, the investor focused on long-term effects is not going to mind if something bought at a discount temporarily gets an even bigger discount.


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