# The Market Completionist

Thoughts on finance, economics, and beyond

### Why Do People Trade?

April 04, 2014 — Evan Jenkins

There’s been a big brouhaha lately over the new Michael Lewis book, Flash Boys, which paints a picture of nefarious high-frequency traders swindling honest investors out of precious pennies every time they trade. I don’t feel I have much to contribute to the is-HFT-good-or-bad debate because I know very little about the actual mechanics of trading, which are necessary to understand what’s actually going on. Rather, I want to tackle a more fundamental misconception at the center of many people’s arguments, namely, the role that trading plays in the markets.

As I’ve mentioned several times before, you can’t go too wrong as an individual simply putting your money in a Vanguard total stock market index fund. Now, putting money in such a fund itself requires an act of trading, even if you’re buying into a mutual fund instead of an ETF: Vanguard needs to purchase more shares of stock to cover your investment. But once your money’s in there, no more trading needs to take place. There’s no need to “rebalance” a value-weighted portfolio of stocks, as the weighting of each stock is proportional to its price.

Even more complicated investment propositions should involve surprisingly little trading, in principle. One common (though possibly misguided) investment trope is that one should keep a constant ratio of stocks to bonds, say 60–40. If the value of your stocks go up relative to your bonds, you should “rebalance” by selling stocks and buying bonds. But now imagine that everybody is taking this advice. If stocks go up relative to bonds, then everybody is going to want to sell stocks and buy bonds. But that means nobody wants to buy stocks and sell bonds! So the price of stocks will have to drop, and the price of bonds will have to rise until the market clears, which happens, you guessed it, when everybody’s back to 60–40. So in fact, no trading ever takes place!

This story (which I should attribute, like most of my finance knowledge, to John Cochrane) highlights the fundamental misconception many people have about markets, that trading drives price changes. When the market goes up, the finance media explains it as people buying, and when the market goes down, it’s people selling. But this is transparently absurd: every transaction involves one buyer and one seller! No matter how the market does, the amount of stock bought is equal to the amount of stock sold. Indeed, there’s no reason whatsoever that price changes need to involve trading whatsoever. In a truly efficient market, if information comes in that affects the price of a stock, everybody should immediately update their quote values. If you learn that a stock that was trading at $20 is suddenly worth$30, you’re not going to find somebody who’s going to sell it to you at \$21, even if they would have a second ago.

Let’s bring in some empirical evidence. A 2004 paper by Brandt and Kavajecz analyzes what drives movement in US treasury yields. First, they cite previous research that the largest changes happen immediately following scheduled macroeconomic announcements. Notably, these changes happen instantly, without any trading. This makes sense: everybody knows these announcements are going to happen in advance, so nobody’s going to leave stale quotes around to get sniped once the announcement is made. After the announcement, market participants can enter new quotes at a new price level.

Brandt and Kavajecz want to explain what causes changes in prices at other times. The mechanism they propose is called price discovery. The idea is based on the existence of information traders: people who have private information relevant to the market and trade based on this information. Information traders have a reason to trade: they know something you don’t! Now, just because somebody is trading doesn’t mean that they’re an information trader. Maybe they’re a noise trader, just trading for kicks (or perhaps some slightly more legitimate reason, like providing liquidity).