Do Computers 'Taming' Volatility Make it Worse?

'I'm sorry Dave, volatility...must...be...controlled.'

The story of computers or robots doing their masters wrong when they were supposed to work to the benefit of humanity has a very long lineage in science fiction. In Carnegie Mellon's "Robot Hall of Fame," there is the fictional HAL 9000 that tried to kill off astronauts on board the spaceship Recovery in the legendary 2001: A Space Odyssey. Not having mastered space flight to such a degree fourteen years after the year that movie was set, however, it seems we still have machines trying to kill off our...investments.

You see, the recent turbulence in global financial markets is now being blamed on trading algorithms designed to...wait for it...limit volatility:

Since the bruising losses of the financial crisis investors have sought out novel and complex ways to play markets more safely. Many have increasingly turned to computer-driven “systematic” investment strategies that aim to maximise returns while mitigating risks — whatever the market conditions...

This has burnished the appeal of the systematic investment industry, the creation of a new generation of scientist asset managers who use complex algorithms to beat the market. Freed from the shackles of human bias and slow reaction, their funds harness computer power to constantly and automatically exploit millions of minuscule investment opportunities, using sophisticated risk management tools that aim to tame volatility rather than be terrorised by it.

Instead of limiting volatility, however, the overall effect of these computer-based strategies may be to increase such volatility:

But the recent stock market turbulence has raised new concerns that these automated and algorithmically-driven strategies are compounding problems, not insulating investors from them. Some analysts and investors fret that the systematic strategies are a financial version of the Cobra Effect. “We have been breeding cobras, and we are now releasing them into the wild,” says Andrew Lo, a finance professor at MIT’s Sloan School of Management. “We ought to be very concerned about this growing phenomenon . . . This is no longer a cottage industry.”

Some analysts fear that the rise of systematic investment strategies has made markets even less predictable, more volatile and potentially susceptible to sudden, inexplicable crashes should the role of algorithmic, automated trading continue to climb. “Every investment cycle is defined by the collective desire to avoid the mistakes of the last one. Taken to extremes, that often becomes the catalyst for the next crisis,” warns Vadim Zlotnikov, chief strategist at AllianceBernstein, an asset manager.

Those favoring algorithm-based strategies need to demonstrate that they do not increase overall volatility using such strategies, but it will be difficult to devise a suitable test. For instance, how can you tell them to lay off for one month and be active another? In the meantime, watch out for the machines. Or, to be fair, the folks with unyielding faith in them.