Algos and the Madness of crowds

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This post is based on a thought I had after listening to Bilal Hafeez on his last appearance on Bloomberg, talking about the impact of the coronavirus on the markets.
I am not an expert in finance by any means and Bilal is essentially a veteran of the industry. He discussed what many others before him have spoken about as well. Algorithmic trading is now a massive part of global financial markets and trading. The thinking goes that because machines are doing a lot of trading, it is possible that they will make irrational mistakes and make the market crash eg during the recent Coronavirus incident.

Modern Algos:
Algorithmic trading is essentially now mainstream. The biggest and most successful of fund of them all is the legendary Madallion fund run by Renaissance Technologies. The fund uses leverage but is capped and not open to outside investors. It is arguably the most successful fund of its size. However, RenTech and its many funds are not the only players. Citadel is also well established in Algorithmic trading and so is the massive Man group on the other side of the pond.
These massive algorithm funds are not simply automated traders from the yesteryears, they use machine learning, neural networks and update their processes with fresh data continuously. That is the reason these funds employ data scientists, statisticians, astrophysicists and everyone in between. they essentially become tech companies doing non stop RnD.

Why they are no different:
However, my argument is that even though Algos, due to their speed and rationality, make the market more efficient, the fear that they can lead to a 'crash' is essential, meaningless. Algos come in all shapes in sizes. For different sectors, different economies, using different variables and working at different speeds.

The variety of algos ensures that they, to a very large extent, work like crowds, although perhaps smarter crowds than the general population. Algos, therefore, would create bull markets, bear markets, and crashes, all of their own. The only consolation can be that perhaps this happens in a much smaller time frame or perhaps with much fewer extremes given that the actors are more 'rational'. However, the 'fear' of a crash due to algo trading is unjustified as that is the very nature of a market.

An example can be value seeking algorithmic funds. They may only invest in Value stocks. However when all Value stocks are exhausted, the growth funds will start investing in perhaps some of the same stocks and when growth seems exhausted, the technical funds will start riding the funds. When the funds with more risk aversion give up, the fund with higher risk aversion will take over and so on. Just like a real market. The fear and greed of the creators (of humankind in general) of the algorithm would be to some extent built-in.

Conclusion:
The black Friday market crash didn't happen due to Algos, neither did the tulip mania nor did the crash and recover of the 1929 NY stock market (as famously mentioned in the book 'Business Adventures').
As an investor or a trader, one should never blame the market (or the Algos), just themselves.

Umair Usman is a Rapid Transformational Therapy Practitioner, a businessperson, and a blogger. You can know more about him at https://buff.ly/2zmc9rj . To book a free consultancy session, please fill the form https://tinyurl.com/y6n2vv8w


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