(Bloomberg Businessweek) -- Was it the computers or the humans? The blame game is on for the wild stock market rout of Monday, Feb. 5, when the Dow Jones industrial average plunged 1,175 points before climbing part of the way back the following day. Some likely suspects: hyperspeed algorithmic trading and a Wall Street stew of complex products that bet on volatility. Another: a record amount of money that has poured into stock funds recently from individuals. Maybe their late arrival—years into a bull market—finally pushed stocks up too high.
There was already selling the Friday before, when a strong jobs report stoked fear that a hotter economy could spur the pace of Federal Reserve interest rate hikes. Higher borrowing costs, the thinking went, would crimp profit margins at companies and sap consumer spending power. For Monday, though, there was no such tidy explanation. No big economic data releases, good or bad. No confidence-shattering earnings reports or geopolitical concerns. Just, apparently, an old-fashioned market freakout, fueled by anxiety among investors accustomed to stocks going in only one direction and traders who had bet on a continuation of the long stretch of low volatility.
Quantitative traders with arcane algorithms are an easy scapegoat when there are abrupt market moves. Probably more dangerous were products that allow traders to short volatility—that is, to bet that the market will stay calm. As stocks went wild, two such securities, with ticker symbols XIV and SVXY, plummeted about 95 percent. The complicated mechanics behind the free-falling securities may have punched up volatility even higher, possibly creating a feedback loop of selling.
In truth, after an unusually long stretch of low volatility and high returns, investors large and small were caught off guard. Individual investors had grown used to seeing account balances only rise. “This probably is coming as a shock” to individual investors, Quincy Krosby, chief market strategist at Prudential Financial Inc., told Bloomberg News. “This was a lesson, and that lesson is that markets don’t just go up, they go down.”
QuicktakeRobo-Advisers
Did mom-and-pop investors really panic? While Wall Street’s computers may be programmed to sell in a nanosecond, many ordinary folks have automated their investments in ways that make it harder to sell. The bull market in stocks has been accompanied by the rise of robo-advisers, the digital investment and planning services that have $220 billion in assets in the U.S. That’s a drop in the bucket—even more individual-investor money is in 401(k) plans and mutual funds—but the success of the business may represent a significant behavioral shift among investors.
Robo-advisers aim to create portfolios that need relatively little attention or maintenance by clients. Users answer questions about their risk tolerance and long-term goals, and a computer formula builds a portfolio, usually of exchange-traded index funds, based on their profile. Portfolios are rebalanced automatically.
The robo-advisers didn’t exactly cover themselves in glory on Feb. 5. Websites for Betterment LLC and Wealthfront Inc., two of the leading robos, suffered short technical glitches as users tried to access accounts. (The much larger Charles Schwab, Vanguard Group, and Fidelity Investments, which offer a broad array of services, also reported issues with their sites.) But even after logging on, customers would likely find it hard to join a race to the exits. That part is by design.
Wealthfront, for example, isn’t set up for rapid-fire trades. Deposits, withdrawals, and changes to risk profiles take at least one business day. Users alarmed by falling prices can switch to a more conservative portfolio, but they have to change their profile, which means answering risk questions again—and they can do so only once a month. Warnings pop up about the perils of market timing, and the site shows a calculation of the compound gains you could miss out on over the years by taking less risk. If the Monday crash turns out to be a blip, many customers of robos may be happy they encountered these speed bumps. “Our clients choose Wealthfront because they share our philosophy that slow and steady wins the race, and emotions should be left out of investing,” said Chief Executive Officer Andy Rachleff in an email. He added that withdrawals by clients don’t correlate to market performance, even when stocks fall sharply.
Still, robo-advisers have grown up in a sunny market environment. In a bear market, will investors be as happy to trust a computer? Mike Sha, CEO of SigFig Wealth Management LLC, a robo-adviser that also offers access to human advisers, says his business model wouldn’t change, but the messaging and conversations with clients might focus more on risk. Even then robos will have one advantage: They won’t have to explain to clients why they thought an exotic bet on low market volatility was such a great idea. —With Dani Burger
To contact the authors of this story: Suzanne Woolley in New York at swoolley2@bloomberg.net, Jeremy Herron in New York at jherron8@bloomberg.net.
To contact the editor responsible for this story: Pat Regnier at pregnier3@bloomberg.net.
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