Challenging the Small Investor as David Against Goliath

— -- According to conventional wisdom, huge investors have a lot of advantages over the little guy, and these advantages create a stacked deck in the stock market game.

But is that really true?

A good example of the supposed oppression of small investors lies in high-frequency (HFT) trading. In this kind of trading, institutional traders set up shop close to exchanges so that trade orders have a short trip and, using Herculean technology, get in front of your trades. These lightning-fast traders snatch a fraction of a cent on each transaction for their own pockets.

The common conception is that this is a form of cheating that comes at a cost to all but the best-funded professionals. Yet ironically, HFT may actually give the average investor an advantage.

This is because it has the effect of reducing the bid/ask spread—the difference between the highest price a buyer is willing to pay for a stock (bid) and the lowest price the seller is willing to accept (ask). Spreads on shares of widely-traded stocks such as Apple have recently tended to be at historic lows, in part because of the price pressure imposed by HFT pros who electronically step in front of you and thousands of other small investors seeking the same price. These pros get to save a tiny bit per share on the large blocks of shares they’re trading. Massive HFT trades create liquidity – a high level of trading activity that reduces the risk that market forces might push up your price considerably between the time you initiate a trade and the time it registers. So if your trade is among the thousands making a set bid that HFT mavens are getting ahead of, your place in this electronic conga line may be a pretty good one.

The practical question is: Are you willing to put yourself in a situation where someone steps in front of you if this still allows you to get a good price and reduce your risk? The answer is probably a resounding “yes.”

This advantage for smaller investors wasn’t possible before the advent of HFT, when not only did big brokerage houses get a chance to step in front you, but it could take them hours to buy or sell big blocks. Now that this process takes milliseconds, the HFT folks can step in front of you but ironically give you price protection in the process.

The little guy has other advantages of the big institutional traders:

• More to choose from. As HFT profits depend on volume, firms that do it can’t derive much benefit from buying and selling thinly traded stocks, so the universe for this trading is limited to about 200 large-cap stocks.

• Investing rather than playing short-term. Little guys can trade to actually invest rather than to gain infinitesimal advantages (multiplied by volume) sought by big institutional investors, who are fixated on extremely short time frames. So individuals shouldn’t care about one-month or single-quarter performance and thus have little pressure to cash out. Instead, they can stay in stocks that carry good prospects for growth. The classic buy-and-hold strategy isn’t really an option for a lot of the big boys, but it is for you.
• Little guys can invest in any stock they want, where as many big institutional investors, such as mutual fund managers, are often shackled to a style (e.g., large cap) or index, and take PR and redemption hits for straying from this assigned style, so they’re forced to stay in their corner of the style box. (A notable exception is Warren Buffett, who invests the money of a huge company with the agility of an individual.) To avoid being fired, pros at most big firms usually must forgo what they view as good investment opportunities outside their assigned spaces. Not that individuals should stray too far too often from their asset allocations.

With these liberating advantages, then, why do individual investors on average do poorly compared with institutional and professional investors? (Various studies have documented this consistent average underperformance for decades.) Because, on average, individual investors find myriad other ways to shoot themselves in the foot, negating these potential advantages that they have as little guys.

Some use their relative freedom and flexibility to freak out, reflexively day trading on every news events, many of which won’t matter much in the long run. Thus, they churn their portfolios, running up costs.

Or, they become fixated on a stock beyond all reason, investing good money after bad with the curiously unshakeable conviction that their initial analysis was correct. In doing so, they may liquidate other stocks that, while not barn-burners, serve a protective or defensive purpose. And over-reacting often means violating asset allocation strategies, throwing balance out of kilter and increasing overall risk to a portfolio.

To make the most of the advantages little guys have, you have be a smart little guy. Little alone won’t do it.

Any opinions expressed in this column are solely those of the author.

Dave Sheaff Gilreath is a founding principal of Sheaff Brock Investment Advisors LLC. He has more than 30 years of experience in the financial services industry, beginning with Bache Halsey Stuart Shields and later Morgan Stanley Dean Witter. At Sheaff Brock, he shares responsibility for setting investment policy, asset allocation and security selection for the company's managed accounts. He also consults with the clients on portfolio construction. Gilreath received his Certified Financial Planner® (CFP) designation in 1984. He attended Miami University in Oxford, Ohio, where he earned a B.S. degree.