Awaiting the Next Crash

“We’ve now dropped three or four hundred points here in the past few minutes,” said CNBC anchor Erin Burnett.

It was May 6, 2010. We now call it the Wall Street flash crash.

You can see why, as other CNBC anchors chimed in.

“Down 900 now! Holy …. I mean, wow. This is just …”

“This is fear. This is capitulation.”

“No. This is just impossible …”

“If you are a retail investor, don’t touch your TV. But also, don’t touch your telephone and call your broker. Not a good thing to do.”

That last bit, which came from CNBC anchor Rick Santelli, was the most prescient. As we now know, the flash crash was just that: a flash. A few computers making trades for hedge funds got confused and flamed out.

It happens. Computers do this. As a PC user, it’s a daily occurrence for me. The flash crash was over in a few minutes, regaining almost all lost ground as quickly as it evaporated. The Dow reclaimed its pre-crash level within a few days.

Sleeping Soundly

I’ve written before that the flash crash was a non-event. Most investors didn’t hear about it until it was over and losses were recouped. It didn’t affect them at all. Australians slept soundly through the whole event.

Most seem to agree it was a non-event. The biggest pushback I’ve received came from a reader who had a stop-loss order triggered by the crash, causing an automatic sale of stocks at wildly depressed levels — an unfortunate incident, but one that highlights the hazards of stop-loss orders more than flash crashes.

Others are still transfixed with the event. Take a recent Barron’s article forewarning about a new risk: a splash crash. That is, “a dislocation by high-speed trading computers that could simultaneously splash across many more asset classes and markets.”

The article goes on to quote the chief technology officer of a company that produces trading software: “I think there is an extreme risk of seeing this because we’re not serious about putting measures in place to police against it,” he said.

Then came a rather amusing statement: “You almost need something like a Norad [the joint U.S.-Canadian North American Aerospace Defense Command]… for the markets.”

When someone compares a minutes-long market hiccup to incoming nuclear warheads, rationality has officially gone AWOL.

Three Types of Risk

It all comes down to the definition of risk. Three kinds of risk pose a legitimate threat to investors. The first is valuation risk, where investors pay too much for good companies. The second is business risk, where companies suffer a misstep that lowers their intrinsic value. The third is leverage.

Flash crashes cause none of these.

They can actually cause the opposite: opportunities to purchase good companies at bargain prices. A market crash caused by a computer glitch that has no impact on a company’s intrinsic value is a public service. Rational investors should beg for them.

In this sense, it’s odd that policymakers view flash crashes with such trepidation, yet have a long history of cheering loudly for market bubbles that wreak havoc on household finances.

Ideally, regulators would welcome opportunities for mum-and-dad investors to exploit computer-driven hedge funds that occasionally go haywire, and warn noisily about the dangers of bubbles.

The fact is that flash crashes caused by high-frequency computer traders harm just one group of investors: those who need to buy or sell shares now. Thankfully, this describes only one group: high-frequency computer traders.

Just Remember These Two Things

All you need to remember are two things. The first is that last year’s flash crash lasted only a few minutes. The second is a famous Warren Buffett quote that’s guided Berkshire Hathaway‘s success over the years: “Only buy something that you’d be perfectly happy to hold if the market shut down for 10 years.”

This article, written by Morgan Housel, was originally published on Bruce Jackson, who has an interest in Berkshire Hathaway, has updated it. The Fool has a flash disclosure policy.

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