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Don’t get caught in market’s rigging

By Sheyna Steiner ·
Wednesday, April 2, 2014
Posted: 5 pm ET

Life is not fair, and neither is the stock market. The actual degree to which the market is lacking a fundamental level of fairness never ceases to surprise, though.

On Sunday, author Michael Lewis gave a now-famous interview on the TV show "60 Minutes" asserting that markets are rigged. High-frequency traders can buy detailed information about pending trades and rush in to buy the stock first to jack up the price using super fast computers and specialized algorithms. For a second of computerized work, they pocket a penny per share, but it amounts to millions of dollars a year.

This is not new, though: Last year, the CEO of the company that bought the New York Stock Exchange, IntercontinentalExchange Group, criticized the way exchanges are run, saying high-frequency traders have an unfair advantage over small investors, The Wall Street Journal reported in November.

Arguably though, the people to whom it's particularly unfair are the buy-side traders trying to do their jobs trading vast quantities of stocks for their very wealthy employers: pension funds, mutual funds, insurance companies and foundations. But, as usual, the people who may end up suffering the most from the stacked decks are small investors.

Studies have shown that the acute phase of the financial crisis in 2008 and 2009 scared many people away from stocks, most significantly the millennial generation.

The ongoing reality of the stock market reinforces the perception that things are really not fair. Rather than protecting the integrity of capital markets, a few people exploit loopholes that add to volatility and basically undermine the way people believe the system works. That is discouraging when you think about it.

"From a behavioral perspective, it appears like individual investors are getting taken advantage of again. The market needs trust from its participants to function," says John Nofsinger, Ph.D., Seward chair of finance at the University of Alaska Anchorage. "How long will individuals trust the market after interest rate manipulation, flash crashes and rigged trading? Which scandal will be the last straw?"

Perceptions in investing

I asked an expert on understanding risk how this latest development in a long line of potentially alarming market news could impact investors.

Here's what risk perception consultant David Ropeik had to say. He's also the author of "How Risky Is It, Really? Why Our Fears Don't Always Match the Facts."

Two important psychological characteristics powerfully shape how worried we are about anything - trust, and control, and this story undermines both. Reading Lewis’s story it seems that not even many of the biggest investors had much control over what they were doing, so naturally a smaller investor will feel much less control.

And certainly this story will further shake trust in financial institutions, including but not limited to stock markets, as just the latest of the flood of recent stories about how greedy insiders are ready and willing to cheat wherever possible in order to maximize personal profits, at the expense of the markets in which we all participate.

All that having been said, I would guess that little will change in terms of small investor participation in the market. That's because the investment basics about how and where and when and why to invest are all still true, and because it is unlikely that small investors will feel personally taken advantage of by this. That, and the fact that the stock market has been rising steadily for some time, and small investors don't want to miss out.

If only investors were rational

History shows that individuals tend to react fearfully rather than investing the way an emotionless computer would. Markets that favor the most cunning and technologically advanced provide a perfect argument in favor of passive investing.

Use index funds or ETFs rather than actively managed funds for most of your portfolio to get the market returns and let institutions fight it out with the algorithms.

What do you think, are markets rigged? Will this change your investing plan?

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Follow me on Twitter: @SheynaSteiner.

Senior investing reporter Sheyna Steiner is a co-author of "Future Millionaires' Guidebook," an e-book written by Bankrate editors and reporters. It's available at all the major e-book retailers.

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