Evaluating Historical Financial Asset Class Returns (Part 1 of 2): Cash, Bond, and Stock Market Returns With And Without Inflation

I’m off on a little camping trip, so I’m proud to allow Larry Russell, a fellow blogger, to contribute.  This is a long article (but with lots of great information), so it will be split into two parts.  Part 2 will publish early next week.

Introduction to evaluating historical financial asset class returns with and without inflation

Very often, long-term historical U.S. asset class returns for the primary stock, bond, and cash financial investment asset classes are presented as:

    • graphics with cumulative long-term returns,
    • simple historical averages, or
    • dense tables of numbers

These approaches can be less than satisfying, because the relative performance of asset classes has varied over time depending upon the financial, economic, monetary, political, and inflationary situation within major sub-periods.

In this article, first I first present 85-year asset class cumulative returns graphics to illustrate this problem. Then, I break down this longer period into five major sub-periods that illustrate how asset class performance has varied depending upon the conditions of that period.

We begin by looking at cumulative U.S. stock, bond, and cash asset class returns from the beginning of 1928 to the end of 2013 with and without inflation. Then, because cumulative stock returns completely overwhelm those of other asset classes graphically, we will look at just U.S. bond and cash returns from 1928 to 2013 with and without inflation.

Later, we will break down 1928 to 2013 into five distinct periods:

    • Stock market crash, Great Depression, and World War II (1929 through 1946)
    • Post-World War II economic expansion (1947 through 1968)
    • Escalation of inflation and increasing economic stagnation (1969 through 1981)
    • Stock and bond bull markets as inflation recedes, including the Dot Com mania (1982 through 1999)
    • Dot Com crash and recovery; then Credit Crisis, Great Recession, and recovery (2000 through 2013)

Major economic, political, and securities market events influenced my choice of 1947, 1968, 1982, and 2000 as the breakpoints in splitting 1928 to 2013 into five periods. No attempt was made to make these five periods be of equal duration. The focus was on selecting distinct periods that could be described by the major economic, political, and securities market events that characterized them.

For the period represented by all graphics, it is assumed that one dollar was invested in each of the U.S. cash, bond, and stock asset classes at the beginning of the first year. No additional funds were added thereafter. Any change in asset value over time represents the total annually compounded gross return (pre-tax without investment expenses) for that asset class. Annual asset class returns include changes in asset market value plus reinvested interest and dividends.

For some of these breakpoints, perhaps one could argue that they should have been made a year or more earlier or later. Being overly concerned about a precise break-point year tends to miss the point. By breaking this 85-year period into five shorter periods, we can more effectively see graphically how the stock, bond, and cash asset classes performed in relative terms. Should you prefer a different year as a break point, simply view the adjacent graphics, note value changes for nearby years, and then make mental adjustments to a particular graphic.

This article includes a total of 14 historical U.S. asset class returns graphics. Seven graphics are provided in terms of inflationary dollars and a corresponding seven in real dollars. For each period discussed, the first graphic presents asset class values using inflationary dollars. Then, the following paired graphic provides the same information in real dollar terms adjusted for inflation. Real dollars represent constant purchasing power over time. (Note that on the screen, the background color of all inflationary graphics is lighter blue, and the background color of all real dollar graphics is darker blue.)

Concerning the U.S. annual data for stock (S&P Index), bond (10 year Treasury Bonds), cash (3 month Treasury Bills), and inflation (U.S. urban Consumer Price Index), several sources were consulted including the Bureau of Labor Statistics, Standard and Poors, Damodaran Online (Dr. Aswath Damodaran, Professor of Finance, New York University Stern School), and Online Data (Dr. Robert J. Shiller, Professor of Economics and Finance, Yale University).

Primary U.S. asset class returns from 1928 to 2013 using inflationary dollars

Over very long periods and especially during the second half of the 20th century, cumulative stock returns have been so high in relative terms that they have dwarfed bond and cash returns. Yet few investors have the luxury of holding only stock investments for decades hoping to capture higher stock returns. Even committed buy-and-hold investors with a high tolerance for investment risk sometimes need to draw cash down their investments to fund unplanned negative cash flow during their working careers.

Note also that academic research has demonstrated that even highly risk tolerant investors tend to benefit from holding at least some minority cash and bond asset positions over time. This is especially true, when there is uncertainty about when an investor might need to draw down some of their equity assets to fund negative cash flow. Unplanned cash flow draw-downs tend to be correlated with the loss of income associated economic downturns, and these downturns tend to be highly correlated with stock market sell-offs.

This 1928 to 2013 inflationary dollar graphic illustrates how stock asset class returns have dwarfed cash and bond returns. One dollar invested in stocks at the beginning of 1928 through the end of 2013 had a cumulative gross total return factor of over 2,500 measured in inflationary dollars.

Cumulative stock returns have been so high in relative terms that this graphic makes it appear that cash and bonds have barely appreciated over this long period. Furthermore, relatively high asset appreciation in recent decades makes it appear that stock investment returns only began to diverge in the mid-1970s to leave cash and bonds in the dust. Later graphics will demonstrate that this was not actually the case.

Primary U.S. Asset Class Returns 1928 to 2013 inflationary dollars

Primary U.S. asset class returns from 1928 to 2013 using real dollars

This graphic presents the same cumulative long-term cash, bond, and stock returns, but the data have been adjusted for inflation. One dollar invested in stocks at the beginning of 1928 through the end of 2013 had a cumulative gross total return factor of about 190 measured in real, constant purchasing power dollars.

In addition, this real dollar chart now makes it seem that stock returns began to diverge from cash and bond returns in the mid-1950s rather than in the mid-1970s, which was suggested by the earlier inflationary dollar graphic.

Primary U.S. Asset Class Returns 1928 to 2013 real dollars

Primary U.S. asset class returns without stocks from 1928 to 2013 using inflationary dollars

From the two charts above, clearly we can learn something about cumulative long term U.S. stock returns, but nothing about cash and bond returns. Since stock returns have been so overwhelming in relative terms, one approach is simply to exclude stock returns if one wishes to understand better relative cumulative cash and bond returns over this 85 year period graphically.

The graphic below indicates that one dollar invested in 10 year U.S. Treasury bonds at the beginning of 1928 through the end of 2013 had a cumulative gross total return factor of about 64 measured in inflationary dollars. For cash returns one dollar invested in 3 month U.S. Treasury bills at the beginning of 1928 through the end of 2013 had a cumulative gross total return factor of about 20 measured in inflationary dollars. Note that over this period urban CPI inflation eroded the value of a dollar by a factor of about 13 times.

Primary U.S. Asset Class Returns without stocks 1928 to 2013 inflationary dollars

Primary U.S. asset class returns without stocks from 1928 to 2013 using real dollars

This chart presents the same cumulative gross long-term cash and bond returns, but the data have been adjusted for inflation. As noted above, inflation eroded purchasing power over this period by a factor of about 13.

This graphic indicates that one dollar invested in 10 year U.S. Treasury bonds at the beginning of 1928 through the end of 2013 had a cumulative gross total return factor somewhat above 4.5, when measured in real dollars. For cash returns, one dollar invested in 3 month U.S. Treasury bills at the beginning of 1928 through the end of 2013 had a cumulative gross total return factor of about 1.5 measured in real dollars.

Primary U.S. Asset Class Returns without stocks 1928 to 2013 real dollars

Long-term investment returns broken down into five sub-periods

The remainder of this article will break down cumulative 1928 to 2013 returns into the five distinct periods listed above in the introduction. For each of these periods, you will find separate graphics of cumulative inflationary dollars and real dollars for the cash, bond, and stock asset classes.

Again, keep in mind that it is assumed that one dollar is invested into each of the three major cash, bond, and stock asset classes at the beginning of each of these five sub-periods. Total gross returns are presented, including asset market value changes plus reinvested interest and dividend payouts. Returns are gross and do not include any taxes or investment expenses.

Stock market crash, Great Depression, and World War II from 1929 through 1946 using inflationary dollars

While the full period includes 1928, this graphic starts with January 1929 values. Doing so emphasizes the behavior of asset classes including and after the 1929 stock market crash, but without the effects of the significant run-up in stock asset values during the 1920s.

One of the first things that this chart illustrates is that stock prices declined in a continuous train wreck until 1932. So much historical memory has focused on 1929 and Black Friday that some people do not realize that the years following were much worse in terms of year-over-year returns.

In the first half of 1929, stock prices had continued to run up, so the full year effect of the 1929 crash was that 1928 year-end to 1929 year-end stock prices prices fell “only” by 8.3%. In contrast, year-over-year stock prices collapsed by an additional 25.1% during 1930, then 45.8% more in 1931, and by 8.6% more during 1932. Measured by calendar years, the cumulative collapse was 65% for 1929 through 1932.

This inflationary dollar graphic shows this 65% value for one dollar invested in stocks at the beginning of 1929. Because it uses annual figures, this graphic tends to mask the somewhat greater peak to trough decline that occurred in stock prices measured on a daily basis. This is not very important, because our purpose is to understand relative behaviors between the asset classes from the 1929 stock market crash, through the Great Depression, and through World War II.

Stock Market Crash, Great Depression, and World War II 1929 through 1946 inflationary dollars

Clearly, an investor with a portfolio much more heavily invested in bonds and cash did much better throughout most of this period until after WWII, when equity prices recovered and almost closed the valuation gap with bonds. However, when the stock to bond gap was at its greatest during the Depression at the end of 1932, in inflationary dollars the initial bond dollar was worth $1.15, while the initial stock dollar was worth only $.35 for a difference of 80 cents. A second peak inflationary dollar valuation gap occurred in 1941, when the original bond dollar was worth $1.59, while the original stock dollar was worth only $.65 for a difference of 94 cents.

In addition to the more well known advantage of bonds and cash versus stocks over this period, there is a lesser know story that this chart tells us. From 1929 through 1932, the U.S. economy suffered cumulative deflation of almost 25%. If you ever wonder why central banks during the more recent Credit Crisis and Great Recession expressed so much concern about deflation and took such extraordinary measures to prevent deflation, the reasons can be found in the 1929 to 1932 period.

Laissez faire national fiscal and monetary policies during 1929 to 1932 period were almost completely hands-off, and securities markets, the economy, and consumer prices were left to find their own equilibrium points. Unfortunately, those were very low equilibrium points that induced a severe and sustained depression.

Economic demand plummeted, because the one-quarter of the working population that was unemployed could afford to buy very little. Moreover, the remainder of the population who still had jobs and/or possessed financial assets did not consume as they might normally. Deflation in the Depression was so pernicious, because declining prices provided an incentive to delay consumption. Particularly during the first five years of the Depression, the cost of products and services declined steadily. Delaying consumption is hardly a recipe for a growing economy, and the 1929 to 1932 period is an important case study for anyone who wishes to understand the deleterious effects of deflation.

Stock market crash, Great Depression, and World War II from 1929 through 1946 using real dollars

The 1929 through 1946 real dollar graphic below adjusts cash, bond, and stock values for changes in the urban CPI over this period. This chart displays asset values in terms of constant purchasing power, and thus the CPI line is displayed as a constant $1 over this period.

Note that the real dollar charts below for each of these five major sub-periods all draw a constant CPI, wherein the CPI is, in effect, adjusted by itself. Holding CPI at a constant $1 value is intended to remind the reader that all asset values on these real dollar charts are inflation adjusted and reflect constant purchasing power over time.

Stock Market Crash, Great Depression, and World War II 1929 through 1946 real dollars

During the worst of the financial collapse from 1929 through 1933, it is notable that a flight to asset safety caused the real dollar value of both cash and bonds to escalate by 50% to about $1.50 for each dollar invested at the beginning of 1929 through 1933. Also, in 1931, stock values had begun to stabilize in real dollar terms and recover unevenly in value between 1932 and 1936, reflecting the fragile financial recovery that began with the New Deal era.

In 1934, cash and bond asset values began to diverge, as the value of holding cash declined over the remainder of the period, while bond values moved upward to peak at about $2 in real dollar terms in 1940, just before U.S. entry into WWII. In contrast, real dollar stock asset values experienced another significant set-back in 1937, as stimulus measures were reduced.

Stepped up economic activity related to war production caused stock asset values to rise throughout the war and almost close the gap with bonds by 1945. However, economic adjustments after the end of the war caused another decline in stock prices, as inflation rose by 8.1% in 1946, 14.1% in 1947, and 8.1% in 1948.

Lawrence J. Russell wrote this article. He is a Pasadena, California fee-only family financial planning consultant and registered investment adviser. He is also the developer of the VeriPlan personal financial planning software.



Copyright 2014 Original content authorized only to appear on Money Beagle. Please subscribe via RSS, follow me on Twitter, Facebook, or receive e-mail updates. Thank you for reading.

Why I Hired A Financial Planner

Note: This is a post by contributor Jim Kelly.  This is timely information because I’m just exploring the possibility of dipping my toes in the water as far as working with a financial planner.  Jim and I share many of the same underlying circumstances in life, so I felt that sharing this info was timely and valuable.

This year we decided to enlist the services of a financial planner. Now, you’re probably thinking that we have to be rich to be able to afford to pay someone else to manage our money.

That’s not true.

My wife and kids and I are your average middle-class family, with a mortgage and bills, just like everyone else. In fact, a lot of people who use financial planners are in the same boat. After managing our finances ourselves for several years, here’s why we decided to go with a professional.

We can handle our own finances, but don’t have time. 

We’ve never bounced a check, we’ve never paid bills late, we have retirement accounts and college savings for the kids, we’re doing all right; but we also know that we could be doing better. Instead of keeping us afloat, our money could be working getting us ahead. But between work and kids and other obligations, we don’t have the time to really spend time on our finances.

Our financial planner does, because he has one job – to manage our money. He also has skills and tools that we don’t have, like years of experience doing nothing but managing money, and access to financial planning software for advisors.

We’ve got big dreams, and we want to make them real. 

In an earlier post, I talked about being realistic when setting big goals. Well, two of our big goals are being able to retire and maintain our current standard of living, and to send our kids to college without saddling them with student loan debt.

While we knew those were both realistic goals, we weren’t entirely sure how to get there. Our financial planner helped us come up with an actual plan for achieving our goals, as well as tracking our progress. Our dreams look a lot more possible now than ever before.

We have kids to plan for. 

Planning for our kids goes beyond preparing for college expenses. Neither one of us had any idea what would happen to our kids financially if, God forbid, something were to happen to the both of us. We don’t like to think about it, but the both of us dying prematurely is a possibility, and we need to be prepared. A financial adviser can take care of all that, so that our kids will be provided for.

Our investment portfolio needed an overhaul. 

As I said before, my wife and I both have retirement accounts, but there really isn’t much rhyme or reason to them. Some of the investments were things that we had chosen ourselves, others were part of our 401K offerings that we never really let go of when we rolled them over.

The truth is that our retirement plans could have been a lot more cohesive than they were. Our financial planner took a close look and helped us come up with a more efficient financial strategy.

For us, hiring a financial planner was the best thing we could have done. Does it cost money? Absolutely, but the peace of mind we get is worth the adviser’s fees. In fact we are better off financially than we were this time last year, even with his fees.

About the Author: Jim Kelly is a husband, father, and a self proclaimed finance geek. Jim is always looking to mainly read and sometime write on PF, especially on his own strategies and struggles. When Jim isn’t nose deep in a blog you can find him on the softball field with his daughter or the soccer field with his son!

Copyright 2014 Original content authorized only to appear on Money Beagle. Please subscribe via RSS, follow me on Twitter, Facebook, or receive e-mail updates. Thank you for reading.

Overpaid And Useless: A Profession That Needs To Go Away

Weather forecasters get a pretty bad rap for their accuracy.

However, this post isn’t about ripping on weather forecasters.  In fact, quite the opposite.  I bring them up so that I can compare them to another group of individuals whose profession  should really be brought into question.

You see, meteorologists often get blamed whenever a forecast is wrong.  If it rains on a day when sun was predicted, they get called out for a ruined picnic or day at the beach.  Clouds instead of the predicted sun can put a big damper on an outdoor activity.  The list goes on.

As I’ve gotten more interested in weather and looking at things, I’ve actually become a lot more tolerant of meteorologists.  If you look at what they do, it’s in fact pretty amazing that they get it right as often as they do.   They look at weather as it stands, then look at things that are happening hundreds, if not thousands, of miles away, and make predictions on what’s going to happen hours, and even days, down the road.  There are many things that can change, each with potential impact on what actually happens.  If you’re on the East coast and reading this, consider that your forecast for what’s supposed to happen is based on weather that hasn’t even hit land all the way across the continent.

What If There Were No More Forecasts?

So, what does this have to do with another profession that is pretty much useless?  I’m getting there.  Stick with me as I stay with the weather forecaster example for just a bit longer.

Imagine, for a second, that meteorologists stopped forecasting the weather.  What if all they did was talk about what already happened?  Think about tuning into the 5:00 news and having the four minutes dedicated to the meteorologist telling you what happened.  The Weather Channel would just talk about the last few days.  Online weather sites and apps would give up to the minute information about weather that already happened.

It sounds pretty useless, doesn’t it.

You’re right.

So, why do Wall Street analysts get to do exactly that?

Reporting News From Yesterday And Beyond

mb-201402wallstThere are a lot of Wall Street analysts out there, and from what I’ve been told, they get paid a lot of money to do what they do.  Which is to come up with snazzy reports with lots of important sounding language that rehashes information that, for the most part, has already been released and is well known.

Where do I sign up?

Upgrades and Downgrades On Yesterday’s News

I’ve noticed a troublesome pattern over the past several years as I track stocks I own or stocks that interest me.  The upgrade and downgrades that accompany reports seem to come out after big news has been announced, and therefore, after the stock market has already moved the stock in response to that news.

Citi, for example, released poor earnings.  The day of the earnings report, twelve analysts released reports that downgraded the stock, after it lost a few percent in early trading.  Wow, really big leap on that one.

In other words, they effectively said “And yesterday’s weather was..”

Do you know how many analysts downgraded Citi leading up to the reports?

Not a one.

Recently Ford has been under a lot of pressure.  A poor earnings reports, reduced guidance for 2014 sales, and a monthly sales report sent the stock on a slow slide.  After it slid for about six weeks, losing nearly 20% of its value, an analyst downgraded the stock, citing risk from the very items which had already been reported as threats to the stock price.

You don’t say.

Where do I sign up?

The Lost Value Of This Profession

Now, it seems to me, that these recommendations and analysis would have been more useful to investors before the report.

Some would argue that the data isn’t there.  Maybe that’s true, but I know that at many rating agencies, there are analysts dedicated exclusively to one company.  All day, every day, their job is to understand what’s going on.  At one company.  So while the company may not (and shouldn’t) release data to that analyst, if they’re not able to get some sense of what the company is doing and how they’re performing, and the challenges or opportunities that go into a report, what value is there in that job?

I’m thinking very little if any at all.

But, these analysts get paid a lot of money.  Probably a lot more than meteorologists. They get recruited from the best business schools.  They are held in high prestige.   Their information gets printed in glossy reports that get sent out all over the place.

But for what?

So they can release a report after the company in question releases theirs to say the same thing and guide investors to do what they’ve already done in the time between the actual drivers and the report being released.

Where do I sign up?

Once Upon A Time

I’m wondering if there was once value in this profession.  Before the internet when news releases were sparse and data wasn’t available and digested within moments of a company announcement, maybe these reports held value.  Back then, a report released hours or days after an earnings announcement may have held value if the market was slower to respond and there were days available to price in a driving factor.

But, that window doesn’t exist anymore.  Earnings, guidance, profits, sales, whatever the drivers are, those bits of data are processed and priced into stock prices in a matter of seconds.

Thanks But No Thanks

At this point, I take analyst recommendations at face value.  What that personally means is that for about every recommendation I see, it’s too little, too late, and it doesn’t tell me anything that has not already been reported.

If you ask me, I’d just as soon they disappear altogether.  And, if you’re used to reading them and wonder what else you could do, here’s a suggestion.

Go look up the weather forecast.  You might actually get some useful information.

Copyright 2014 Original content authorized only to appear on Money Beagle. Please subscribe via RSS, follow me on Twitter, Facebook, or receive e-mail updates. Thank you for reading.

Taking the Risk Out of Trading

Many people believe that being financial independent and in control means that you have to play it safe and not take any risks. However, this can mean that your money will remain safe without ever accruing much wealth. With banks accounts offering little or no real interest nowadays, it is impossible to get rich putting your savings into a bank account. Investing might seem like the better option although it is fraught with risk and, as such, many people are put off. Here are our top tips to take the risk out of trading and investing:

Plan, Plan, Plan

You can never be too careful when you’re investing your own money. There are so many different guides available on investing and trading that you can take advantage of for free. The more you can plan and learn, the lower the level of risk that you are taking. Once you’ve learned the basics, you can begin to look at trading strategies and trading styles. There really is a wealth of material available and, the more you read, the more educated your decisions will become, eliminating much of the risk involved.

Scour the Market and Seek Expert Advice

Always remember that the trading market is vast and, as a result, it is always best to shop around for the best deal. Nowadays, there are so many brokers competing against each other that each one is looking to gain a competitive advantage by offering additional services. Features such as newsrooms, mobile trading and social trading are all optional extras that you should be aware of and should actively seek when you’re opening an account. Remember that any optional bonus can keep you ahead of the markets and enhance your knowledge, thus lowering risk further.

Try Before You Buy

If you’re unsure as to whether investing is right for you then you should seriously consider trying before you buy. Nowadays, many companies offer demo trading accounts and, as a result, you should always make sure that you utilize this feature before taking the plunge. This way, you can be absolutely certain that trading is right for you before you start investing your own money. If you just start trading without checking, you maximize the risk, exposing your savings in the process. It is always better to make mistakes when it doesn’t cost you a single penny.

To conclude, although trading is inherently risky, there are ways that you can limit this in order to maximize any potential returns on your investment. By taking these very simple hints and tips on board, investing will become easier than ever and you should start maximizing your income in no time.

This was a guest post.

Copyright 2014 Original content authorized only to appear on Money Beagle. Please subscribe via RSS, follow me on Twitter, Facebook, or receive e-mail updates. Thank you for reading.

What’s New This Week? (Plus A Roundup)

A few updates and random thoughts, followed by some great posts I hope you check out:

  • A few weeks ago I wrote about how our IT department is being insourced.  We have received a few more details.  Our official offer letters should be arriving any day now.  They were promised by the 15th, so if that still holds, I’ll know what’s what in a week.  We did find out that our years of service will be credited from when we started, so I’ll come in with six years of service.  This means I’ll get roughly the same amount of time off as I do today, and has a few implications for benefits and such.  There is a lot of nervousness that they’ll be coming in offering less pay than we make today.  I think that’s just normal jitters, and I’m staying optimistic that it’ll be the same or better as what I am getting today.
  • Did you hear about the Walmart glitch on Wednesday where the website had prices mb-201311mistakeof various items at outrageously low prices?  I sure did.  I found a 55″ TV for $329, and while it was sold out online, it said that my local store had one.  Which, when I called, they confirmed that they did.  But, they were already aware by that point that the prices were a mistake (they had $800 treadmills ringing up for $33, computer monitors for $9, and new release video games for $17), and were not honoring those prices.  I read a few forums where people said they got in and picked up stuff right away, so it sounds like a lucky few were able to take advantage of the glitch, but sadly, we did not find an easy way to replace our damaged TV.
  • As a Ford stockholder, I’m a little annoyed at the activity on the stock.  Ford beat earnings a couple of weeks ago, and hit over $18 per share.  Since then it’s been on a somewhat steady decline, around the mid-$16 range, all on virtually no news.  I think institutional investors want a dividend increase, and are passively letting Ford know that they need to increase the payout.  Hopefully the stock reverses course soon!

Here are some great articles I thought you’d enjoy as well as listing a few carnivals I’ve been included in recently:

  • Money and Potatoes has been making some side money by selling plasma and blogs about all aspects involved, financial and otherwise.
  • Monica on Money lists eight warning signs that you might be living beyond your means.
  • Krantcents outlines a subtle difference between a wish and a dream, then goes on to illustrate how one can lead to big rewards if you take hold of it.
  • I’ve often thought that Baby Boomers, in addition to working hard, had a good set of circumstances in terms of some of the benefits associated with their careers.  Little House in the Valley expands on this and compares it to the Gen X and Gen Y groups.
  • Reach Financial Independence – Carnival of Personal Finance
  • According to Athena – Carnival of Personal Finance
  • Bite The Bullet Investing – Carnival of Retirement
  • Frugal Rules – Yakezie Carnival
  • Save Spend Splurge – Carnival of Personal Finance
  • Wealth Note – Yakezie Carnival
  • Figuring Money Out – Yakezie Carnival
  • Money Wise Pastor – Yakezie Carnival

Hope you have a great weekend!

Copyright 2014 Original content authorized only to appear on Money Beagle. Please subscribe via RSS, follow me on Twitter, Facebook, or receive e-mail updates. Thank you for reading.

Two Seconds And Why High Frequency Trading Always Wins

Two seconds.  It probably took the average reader two seconds to read this.  Not much can happen in two seconds, right?


It turns out that two seconds can make all the difference in the world in the financial markets.  Enough to make (or lose) a fortune, as it turns out.

Economic Reports

OLYMPUS DIGITAL CAMERAOne of the big drivers of the stock market are economic reports that come out at various periodic times.  Weekly jobs reports, manufacturing data, consumer data, unemployment rates, and a whole host of other things are key drivers of the market.

Long story short, what will happen is that the market will guess at what the data will be.  Say they expect unemployment to go from 8.0% to 7.8%.  The actual number will often drive the market.  Though other factors are at play, if the number came in at 7.6%, it’s a good bet that the market will rally, whereas if it were to come in unchanged at 8.0%, the market would sell off.

Seems pretty straightforward, and at first glance it seems like you can trade with that data.  But, in many cases that assumption would be off.  It’d be off by two seconds, to be exact.

Early Access

See, some economic reports are now available for delivery in advance of the release to the general market.

Two seconds before the release, to be exact.

Yes, if the report is set to be released at 10:00 AM, you can pay to have it made available to you at 9:59 and 58 seconds.

Hardly seems like a big deal, does it?  But, as it turns out, two seconds can be a lifetime when it comes to computers and high frequency trading.

In two seconds, a computer can receive the report, open the report, scan the report, parse out any pre-determined words or phrases, determine if the report is favorable or unfavorable, put in orders, and have the orders executed.

This can and does take place all within the space of two seconds.

That means that anybody that doesn’t have that advantage (meaning every individual investor out there) is always going to be too late.  You can have an order at the go, hear ‘positive’ at 10:00 and 2 seconds, hit ‘Execute Trade’, and you’re still going to have missed out.  Not only will the computers have ‘heard’ the data already, they’ll already have acted on it.  You’ll be behind the eight ball.

Every single time.

I’ve long been critical of high frequency trading, and the impact that computers have had on the market.  Proponents of high frequency trading argue that the benefits are there for the market.  By making their trades quickly and trading even to make a penny per share, they are offering liquidity to the market, meaning that the exchanges can match up buyers and sellers very quickly.

That’s all fine, but when you consider that, on a basic level, every transaction has one winner and one loser, it becomes pretty apparent that the high frequency traders rarely lose.

Meaning someone else does.  And, guess who that someone often is?  You.  Me.  Whoever.


I don’t think high frequency trading should drive individual investors away from the market.  There’s no reason for this practice to cause complete mistrust in the market, but it should set expectations.

Don’t expect to beat the market.  You can’t (at least not on a regular basis).  You can still grow your investments, just don’t think you can be the hotshot that beats the market.

Don’t expect to beat the computers.  Even without the two second head start, the computers can still generate trades based on real time data that will beat you.  They scan the newswires.  They process the data.  They make their trades, both buying and selling, all before you can finish reading the same headline that they’re using.  Meaning, if Ford announced that they doubled earning projections, go try to put in a trade, whether it be during market hours or during pre-market trading.  You’re going to find the price already reflects that.  The big money has already been made.

By the computers.

Readers, what are your thoughts on high frequency trading?  Is the two second advantage fair or should it be regulated away?  (Personally, I don’t think it would even make a difference)

Copyright 2014 Original content authorized only to appear on Money Beagle. Please subscribe via RSS, follow me on Twitter, Facebook, or receive e-mail updates. Thank you for reading.