Computers have already changed how we live, work, invest and do business immeasurably and more changes are still coming. On Wall Street, for instance, there has especially in the financial markets.
That's according to J.P. Morgan, a major investment firm, which recently published a report that says about 60 percent of the stock market is controlled by passive investments — exchange-traded funds (ETF) and index funds, for instance — while active investments, which mostly rely on trend investing, now own a mere 20 percent of the market. That means that automated investing collectively accounts for 80% of the stock market. In other words, either for long-term investing or equities trading, money managers commit up to 80 percent of funds in the market to computer algorithms.
How are computers at work in investing
Portfolio Rebalancing: Take, for instance, a pension fund that is meant to hold 55 percent stock and 45 percent bonds. If the value of stocks increase after a few years such that stocks now take 60 percent of the portfolio, rebalancing is required. This involves the sale of certain stocks based on certain conditions. Nowadays, computers are tasked to carry out portfolio rebalancing.
Arbitrage: this refers to the trading activities aimed at profiting from tiny market discrepancies such as asset trading at different prices on different markets. Because these discrepancies usually only last for seconds, computers are better suited to profit from them.
Computer algorithms are also used to determine the average price of assets at a certain time and instructed to buy or sell the asset when the market price is above or below the mean average price, respectively.
Pitfalls of Investing or Trading on Autopilot
In passive investing: While automated long-term investing helps drive cost down, which increases investor return (part of the reason it's growing in popularity), some experts believe that it's encouraging herding behavior in which just a few people's research dictate the investment decision of millions. That could bring overcrowding and, eventually, the overpricing of an asset.
In active investing: since this largely involved making trading decisions based on short-term trends and headlines, added to with the fact that computers can respond faster than humans, the market may become overly sensitive and hence become more vulnerable to sharp price swings that are completely unconnected to fundamentals.
How Investors Should React
While algorithmic trading could save time and money, it's still just as important as ever to conduct your due diligence when investing in any asset. Having a personal investment blueprint crafted out of proper research could help in avoiding falling victim of herding in passive investing or unnecessarily responding to algorithm-driven short-term price swings.
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