Deciphering the ‘Flash Crash’
Yesterday the market experienced what is now being referred to as the ‘flash crash’ – the Dow Jones Industrial Average dropped as much as 9.9% during the day before rallying to close down 3.1%. Leading the dramatic mid-afternoon decline was Procter and Gamble, which at one point fell a stunning 36.4% before reversing to close down just 1.9%.
Investigations into what exactly caused this momentary plunge of stock prices are already underway. It seems clear, however, that a contributing factor was the cascading effect of high frequency trading – the rapid automated buying and selling of stocks driven by computer algorithms.
For example, in an attempt to protect against further losses, the computers may be programmed to sell as stock prices fall to certain levels. This can lead a quick market decline to be self-perpetuating as stock sales are continually triggered with each incremental drop in prices.
The great danger of this type of trading strategy is the danger inherent to all forms of market timing: it only proves successful if the investor is subsequently able to re-enter the market at even lower levels. This proved especially costly to many such traders yesterday as large stock sales were automatically triggered by the abrupt market decline only to see prices then reverse suddenly and dramatically.
It will be interesting to learn the conclusions of investigators into yesterday’s chain of events. However, while the sources of the intraday volatility may be unique, investors should recognize that the volatility itself is not. Though fortunately infrequent, history shows that the market will experience days such as yesterday.
As the European debt crisis unfolds, uncertainty in the global markets may well result in continued volatility and price declines. As investors, it’s critically important to separate what we can control from what is beyond our control. While we cannot control whether or not the market decline will continue, we can control how we respond. And it is our response in the face of short-term market events that will drive long-term portfolio results.