College 101: How Investors Make Decisions
I think I have a decent grasp on the basics of the stock market. I know that the sooner that you start saving for retirement, the better, and I know that I should invest a lot of what I save. And I know that, generally speaking, it’s a good idea for investors to just buy and hold stuff like index funds (right?). But I’m curious about how investors who take more aggressive strategies actually make their decisions. What causes speculators to buy and sell investments quickly? Clearly, not everyone is just buying and holding!
That’s certainly true! While many investors choose to buy and hold index funds or portfolios of diverse stocks and other investments (a strategy that, according to the conventional wisdom, is a pretty wise one), it’s also true that plenty of professionals, day traders, and amateurs try to “beat the market” by swapping stocks and bonds more aggressively.
And, actually, that’s part of what makes the stock market work. The higher the trade volume, the more stable the price of securities; if you try to buy a stock for what it’s worth when nobody is selling that stock, you may end up paying a premium. So it’s good that we have folks out there trading stocks all the time, at least to an extent!
But how are they making their decisions? It varies, say trading strategy consultants we spoke to. Trading strategies may be simple or complex, modern or old-school, and gut-based or formulaic. Financial firms are always trying to discover the secret recipe to the ultimate trading strategy, and while nobody has found it yet, there are plenty of interesting and innovative strategies being used in the market today.
One thing that has changed the way we trade stocks is the arrival of algorithmic trading. An algorithm is a process for solving a math problem in a finite number of steps. In the context of investing, that means calculating whether to buy, sell, or hold a given stock or other type of investment property given its underlying numbers and the shape of the market as a whole.
There are some concerns about algorithmic trading, which makes high-frequency trading (trading at faster speeds and higher volumes) easier. The diversity of strategies used on Wall Street is part of what keeps the market working; some fear that computers could make similar decisions and, with high-frequency trading, spark more dramatic consequences than would be possible with human trading. A run on a stock might go more quickly and do more damage with computers and set formulas, these experts suggest. What if the computers, following code over common sense, make a mistake? To what extent they’re right remains an open question, but at least some experts believe algorithmic trading strategies played a role in a recent market correction.
What we know for sure, though, is that computers and innovative algorithmic strategies will continue to emerge. On Wall Street, coming up with something new is always a popular strategy.
“Know what you own, and know why you own it.” -- Peter LynchSubscribe to The Daily Cardinal Newsletter