Price Distortions and Emotional Investing

On August 24, 2015, when the markets took a nosedive, there were a lot of price distortions in the morning. The DOW opened down over 1,000 points and many individual stocks were down 20% to 30%. The selling was so dramatic, it triggered unprecedented emergency freezes on stocks. Stocks and exchange traded funds (ETFs) were automatically halted more than 1,200 times, according to NASDAQ. More than 600 of these halts were on ETFs alone. These freezes were created by circuit breakers, which were installed after the May 2010 flash crash, and were designed to slow down dramatic selling or buying. Structured as an automatic time out, the trading is halted for a five minute period, giving investors a chance to calm down, and allow cooler heads to prevail.

If an investor traded out during this period, or was passively investing with stop limits, their portfolio could have been seriously damaged by this unusual situation. For instance, if the price distortion caused the ETF price to blow through your top price limit, this may have triggered a sell. The distortion didn’t mean that the net assets in the ETF were less valuable, it simply meant that the ETF was trading at a huge discount due to the lack of buyers and an increase in sellers. The potential result, however, was that the passive investor ended up selling at the bottom, in the middle of a panicked day.

While the market ended down 4% on August 24, an investor in this scenario may have given away 20% - or even 30% - due to their passive strategy. The people hurt the most during that very strange day were likely not the hedge fund traders, rather those whose market orders or stop limit orders were filled, selling out at an unnecessary loss.

- Greg Stewart, CIO