The Age of Algorithms

Last time, we watched the dot-com bubble swell and burst, and then traced how the 2008 global financial crisis shook the world, driven by the runaway magic of securitization. Once the crisis had passed, the market was left with deep mistrust and a determination never to repeat the same mistake.

But it was not only rules and regulations that changed after the crisis. The way the market itself moved was quietly, yet fundamentally, transformed in places beyond our sight. It was no longer humans who placed the orders, and the unit of competition grew far shorter than a second. At the same time, a plain kind of investing that required no difficult thinking slowly came to cover the world. In this chapter, let us look at the strange new face of a market whose protagonist was shifting from people to machines.

A battlefield of a thousandth of a second — the rise of high-frequency trading

Once, buying and selling stocks meant people shouting on the floor of an exchange, trading orders with gestures and hand signals. In time, trading became electronic, and orders came to be processed by computers over communication lines. Then a group emerged who pushed that speed to its very limit. The method came to be known as high-frequency trading, or HFT.

High-frequency trading refers to using fast computers and lines to seize the tiniest price differences, automatically repeating large volumes of orders in units of a thousandth of a second. It is a world far beyond anything a human watching a screen could keep up with. Even if each individual profit is minuscule, repeating it an enormous number of times is said to be how gains accumulate. A competition even arose to place computers right beside the exchange, shaving off even the slightest delay in communication.

The event that laid bare that fragility came on May 6, 2010. American stock prices recorded an abnormal swing, plunging within mere minutes and then soon recovering. Later called the ‘Flash Crash,’ this momentary collapse is said to have been caused in part when a massive automated sell order set off a chain reaction among automated trades, buyers vanished in an instant, and liquidity dried up. A market beyond human hands can run wild in ways no human intended. It was an event that thrust this truth before the world. In response, mechanisms to put a brake on sudden price swings were put in place across markets.

Thoughtless investing covers the world — the quiet revolution of the index

While machines competed on speed in the market’s spotlight, another, entirely different current was spreading — plainly, yet surely. This was index investing.

Its origins go back far earlier than the crisis. To simply track an index that shows the market’s average movement — the man who spread this idea of an investment fund to the world was the American John Bogle. In 1976, he is said to have launched an index-tracking investment fund for individual investors. At first, it was reportedly mocked by the industry as ‘an un-American idea that gives up on beating the market from the very start,’ and the money it gathered was said to be very small.

Why did an investment that did not aim to win gather support? One reason was that by keeping management effort low, the costs borne by investors could be kept low. As the view spread that, however hard many experts tried to beat the market average, winning against the average over the long run was difficult, the idea of simply buying the average itself cheaply came to carry persuasive weight. That said, tracking the average also means falling together when the whole market falls, so it is by no means an all-powerful method. Even so, this ‘thoughtless investing’ seeped into the world over time.

Individuals return to the market — the age of online brokerages

If cutting-edge technology like high-frequency trading belonged to a select group of specialists, the same information technology also worked in exactly the opposite direction. It once again invited ordinary individuals into the market. The driving force behind this was the online brokerage.

In Japan, major turning points overlapped at the end of the 1990s. In 1998, a service that pioneered stock trading over the internet appeared, and the following year, 1999, the previously fixed commissions on buying and selling stocks were said to be fully deregulated. With this, an era began in which firms competed to lower their fees. Trades that had once meant visiting a brokerage counter and placing orders through a representative came to be something anyone could do from a home computer, and in time a smartphone screen, for a tiny fee.

Stock investing had once had an aspect of belonging to people with substantial funds and specialized knowledge. That changed into something one could buy and sell from small amounts, without worrying about fees, by one’s own judgment. The fact that clear options like index investing had spread also gave this trend a push. Without having to choose difficult stocks, one could steadily accumulate products that tracked an index — such an entrance to investing was opened to many people.

In this way, a strange two-layer structure was born in the market. On the front line in plain sight, ultra-fast machines invisible to the human eye shaved away at thousandths of a second against one another. Behind them, countless individuals in front of their screens built up their assets little by little over long stretches of time. The market’s protagonist was no longer the trader shouting on the floor, but had shifted to invisible algorithms and to invisible individuals, one by one. Machines that perfected speed, and individuals who nurtured slowly. The wonder of this present age lies in how these two opposites coexist in the same market.