Security badge photo of mysterious Wall Street trader

On May 6, 2010, the Dow Jones Industrial Average declined 348 points (-3.2%).  Not a good day, but a rather unremarkable decline from a long-term perspective.  However, what happened during the day will be remembered for a long time, as this was the day of the “flash crash”.  The market had been weak throughout the day, but in the afternoon the bottom fell out, if only for a matter of minutes.  The Dow Average accelerated to the downside, at one point showing a drop of more than 1,000 points from the prior day’s closing price.  Just as quickly as it went down, it then reversed course and recovered most of the decline.

Many commentators were quick to point the finger at flash trading, a form of rapid, computerized buying and selling of securities for small profits on each set of transactions.  They claimed that these short-term oriented traders were bad for the markets and hurt other investors.  There may be some truth to that, but are we seeing the wild action on May 6 for what it really was?  Was it really just a case of “computers gone wild” where pre-programmed algorithms put through trades that no human would be foolish enough to do?

A recent article by E.S. Browning in the Wall Street Journal shed some light on the idea that maybe humans played a part, after all.  Browning wrote the following about the trading at a brokerage firm that is popular among investors:

Long-term investors have been showing a distinct change in behavior since 2008. Jay Pestrichelli, who monitors client behavior at online brokerage firm TD Ameritrade, has noted a change in the traditional buy and hold strategy. "People who once made few changes to their accounts have begun trading more frequently," he says. He saw the trend especially clearly on May 6, when there was an uptick of selling.

"A higher percentage of our trading was coming from our longer-term investor base," he says. People who might log into their accounts regularly, but not necessarily trade, were selling heavily that day, he says.

"The next day, those clients were all buying back in," he says, often losing money on a trade where they had sold low and bought higher. "To see that kind of a move in such a short period of time, it certainly can shake their trust."

We’ll probably never know the full story of what happened that day, but it looks like it may be more familiar than we immediately assumed.  The stock market had topped out a few weeks earlier in April and some nervous investors had their trigger fingers ready to sell stocks at the first sign of weakness.  After seeing the market bounce back from its mini-crash, some investors even bought back in the next day.  This is indeed the old story of investors making decisions based on emotions and it’s been happening since long before computerized trading came to dominate the markets.  Maybe it should have been called the “emotion commotion” instead of the “flash crash”.

(A Google search reveals that Jeff Beck recently released a new CD titled “Emotion & Commotion”, which could create a copyright issue.  That’s probably why they went with “flash crash”.  Sticking with the theme of popular musicians in the 70’s and 80’s, I guess my message is that investors should stop blaming Mr. Roboto and start with the Man in the Mirror.)

As Browning’s article also notes, some investors have lost faith in the stock market due to these events.  None of us enjoy the fact that the markets go crazy from time to time, but we don’t think it changes the long-term case for investing.  Employees will keep showing up to work and companies will continue to earn profits.  We provide capital to companies in order to share in their long-term success, not to measure their stock quotes on a minute-by-minute basis.

Many investors left the market after the “real” one-day stock market crash on October 19, 1987, when the Dow Average plunged a record -22.6%.  No doubt, that type of drop would shake almost everyone’s faith to some extent.  Nonetheless, the Dow Average ended at 1739 that day.  It is nearly six times that level today and that does not include dividends earned along the way.  So it certainly wasn’t a good decision to permanently avoid stocks back then and we don’t think it’s likely to be a good decision this time either.

*The Dow Jones Industrial Average is comprised of 30 stocks that are major factors in their industries, and widely held by individuals and investors.