Even Michael Lewis Still Has Faith in the Market

Michael Lewis readily admits that he set off a firestorm when he declared on 60 Minutes that the “stock market is rigged” and that individual investors are getting scalped by high-frequency traders. Within hours of his appearance, Wall Street dignitaries cried foul, and a host of regulators announced investigations into high-frequency trading, the topic of Lewis’s latest book, Flash Boys: A Wall Street Revolt.

Lewis was drumming up publicity for his new book while drawing attention to a corrupt practice that he thought regulators were ignoring. But what he wasn’t trying to do, he tells me, was encourage investors to abandon the stock market. “That would be crazy,” Lewis says. “It’s offensive that individual investors get ripped off by a penny or two when they trade. But that economic impact is overwhelmed by what happens with the performance of their stock.”

Lewis has a well-earned reputation for entertainingly explaining complex topics, ranging from the business of baseball (Moneyball) to the 2008 financial crisis (The Big Short). The former bond trader says investors shouldn’t change their strategy as a result of anything he has written. But he encourages them to help fight the systemic market problem he uncovered.

From just $107.88 $24.99 for Kiplinger Personal Finance

Become a smarter, better informed investor. Subscribe from just $107.88 $24.99, plus get up to 4 Special Issues

CLICK FOR FREE ISSUE

Sign up for Kiplinger’s Free Newsletters

Profit and prosper with the best of expert advice on investing, taxes, retirement, personal finance and more - straight to your e-mail.

Profit and prosper with the best of expert advice - straight to your e-mail.

Sign up

What’s it all about? The short version is this: With the help of exchanges (which profit from increased volume) and laissez-faire regulators, high-speed traders engage in the practice of front-running—that is, knowing what others are getting ready to buy and buying it before they can execute their trades. Most exchanges encourage front-running by executing ordinary investors’ orders via slow-speed connections that high-frequency traders can easily outrun, Lewis says. By buying a fraction of a second before other parties do, the high-frequency crowd can sell immediately thereafter and make a profit.

The profit is tiny: a penny or two a share. So an individual investor would have to trade thousands of shares before all this high-speed trading would cost him or her the equivalent of, say, a modest brokerage commission. But because high-frequency traders do this millions of times each day with thousands of stocks, investors effectively pay an invisible tax on trading, says Lewis. In the aggregate, light-fingered high-speed traders pick billions of dollars out of individuals’ pockets each year. But in a multi-trillion-dollar market, each investor’s loss is too small to notice.

The price we pay. What may be more important, Lewis says, is that high-speed trading contributes to increasing volatility and bizarre market moves, such as the Flash Crash of 2010. That causes people to lose faith in the stock market and may be one reason millions of Americans would rather sit on the sidelines than play in a game they think is rigged. “Some number of dollars will not go into the market because of a lack of trust in the system,” Lewis says. “We all pay an economic price for that.”

Investors have a way to fight back. They can ask their brokers and fund companies to route their orders to a newly created trading platform called IEX, which has pledged not to allow front-running.

In the meantime, Lewis says, investors shouldn’t sweat the increasing volatility that high-frequency trading helps advance. “In the long run, you’re buying a piece of the U.S. economy” when you buy stocks, he says. But he admits he’s made a change in his own portfolio to adjust for the possibility of a meltdown precipitated by high-frequency traders. “I’ve moved some money out of index funds and into Berkshire Hathaway stock,” he says. “I figure if the world falls apart, Warren Buffett will be in a perfect position to exploit the wreckage.”