The Flash Crash—and Learning to Love Volatility

Eleven years ago yesterday, I had a late-morning dentist appointment and didn’t get to the office until around lunchtime on the West Coast. Ordinarily, this would not be noteworthy. But when I arrived, the whole floor at Fisher Investments’ San Mateo office was buzzing. Something about the market crashing almost -10% in an instant, orders getting canceled and phones ringing off the hook? And I was a bit confused because when I fired up the old Internet machine, the S&P 500 was down only about -3% on the day—a big daily move, but also a lot less than -10%. That is the story of how I experienced the Flash Crash: as a strange intellectual curiosity that must not have mattered much—it was literally over before I heard about it.

To the rest of the financial world, though, it seemed like a very big deal—and remained so for years. The general consensus held that this 36-minute freakout must be evidence of something very wrong in markets. A July 2010 Atlantic article summed up the general mood: “How could our vaunted markets be so brittle? Did anyone know what the hell was going on? All kinds of hypotheses were floated. Hackers! A buggy automated trading program! Something more sinister! No one knew quite what happened, but it was clear that computers trading stocks had something to do with it.”^[i]

Headlines chewed over it for months, speculating over the causes, potential technical glitches and the risk of a repeat. Regulators’ official report, released five months later, only entrenched those fears by pinning the crash on a single institutional investor selling $4.1 billion worth of stock index futures at warp speed (apparently without trying to mitigate market impact or other implicit costs), which then triggered an avalanche of algorithmic orders as the market fell.^[ii] That fanned fears of weak plumbing, and for the next several years, every May 6, the anniversary retrospectives rolled in, all recapping what went wrong and speculating over whether the problem was fixed. “Why We Could Easily Have Another Flash Crash” was an actual headline in 2013 that summed up the general mood.^[iii]

Shortly before the five-year anniversary, a fresh breakthrough stole headlines when a British trader was arrested for alleged market manipulation over the two hours before that $4.1 billion sale, which regulators claimed made the infrastructure vulnerable. That spawned a fresh avalanche of commentary and questioning, as did his eventual jailing, guilty plea, fining and sentencing to home detention. Why did it take five years to discover? Was he a scoundrel or an undeserving scapegoat? How many others were executing similar trading strategies? Was the underlying vulnerability still there? That line of discussion continued the rest of the decade, culminating in a book released just in time for the 10-year anniversary.

In most of those years, there didn’t seem like much actual meat to cover on this website. That changed this year, when there was … nothing on the anniversary. No noise. No retrospectives. We did see a tiny burst of volatility on the London Exchange dubbed a “Mini Flash Crash” earlier this week, but that was it. The silence reminded us just how loud all of that noise was in years past.

That, in turn, brought to mind a long-running theme in how people react to market movements big and small. When it happens, volatility can make people think things are the biggest deal in the world and must have some huge cause—recency bias at work. The Flash Crash is a mega-example, but there are others. If stocks drop after a Fed meeting, then whatever the Fed did or said must be huge. Stocks fall after word leaks that President Joe Biden is set to propose jacking capital gains taxes sky-high? Obviously the end of the world. Market drops for no apparent reason? Clearly something big, bad and ugly must be brewing under the surface. This year alone headlines covering everything from GameStop to Archegos may make the market feel shaky. Yet volatility has been below average.

Beyond the alleged causes for past stock swings (or the lack thereof), there is a basic, if tautological, explanation: Volatility is just volatile. It can happen for any or no reason. Maybe sometimes it is tied to investors’ (or algorithms’ or market makers’) reaction to a given event. But maybe sometimes it is just Tuesday. Or Wednesday. Volatility is just market movement, and that isn’t inherently problematic. After all, if markets don’t move, they don’t go up. Sure, in the Flash Crash, an institutional investor’s algorithm did something a little bonkers, which made some other algorithms go bonkers. But it evened out so quickly that it is hard to discern the event on any chart of any meaningful timeframe including it. In 45 minutes, it was here and gone. If there is a better reminder that volatility is self-correcting, please let us know.

A key lesson for investors from this 11-year-old saga is that hating volatility is a waste of energy. It is challenging for many to accept, but volatility is not only the price tag of stocks’ high longer-term returns, it partly explains and generates them. It isn’t all bad. It cuts both ways, and it comes in what Fisher Investments’ founder and Executive Chairman, Ken Fisher, likes to call “clumpy patches.” Longer-term rises come when the clumpy good outweighs the clumpy bad, and some of history’s best years have had some jarring, bad clumps. The best way I know of to avoid a reactionary mistake is to just lean in and love it, and remember that it all fades in the long run.