The little man is king

Wall Street is feeling threatened by small-time internet traders. The City should, too, writes Richard Thomson from New York

MATTHEW STARKY, a 28-year-old graphic designer, knows exactly where and when he became a stock market junkie. It was on 24 April last year, at 12.10pm precisely, in his sublet bedroom in Manhattan's East Village. He bought approximately $5,000 (pounds 3,000) worth of Microsoft stock and $3,500 of Cisco Systems with money he had inherited weeks before and was not sure what to do with. He used his laptop to send his order skimming across the internet to an online discount broker called E*trade which a friend had recommended, paying a mere handful of dollars in commission. Since then, his holdings have nearly doubled in value and he has been pumping his other savings into the market like a hardened professional.

"Those first trades got me hooked," he says. "I'd never have dared put so much into the market if my friends hadn't all been doing it already. Some of them had made thousands of dollars, so I thought: 'What the hell. I'll hate myself if I miss out on this without trying it.' I watched those share prices every day, and they went up like magic. Whenever they went down I was somehow sure they would recover, so I never sold."

Short, slight, with a fashionable goatee and a gold earring, Starky hardly resembles the traditional image of a market speculator. Yet he is typical of a fast growing group of ordinary Americans who have discovered the joys (and frustrations) of share dealing and are changing the way the US stock market and, indeed, Wall Street itself operate.

Starky and his kind are something completely new to the New York stock market: a force that is changing all the old certainties and power structures. In another way, however, he is absolutely characteristic of American culture, with its enthusiasm for new ideas and new ways of making money, and its instinct for democracy. For Starky illustrates that the stock market is no longer a place just for the elite. The masses are crowding in via the internet and a startled Wall Street is having to rethink its place in the world.

It is a development the City of London establishment would do well to watch. Though speculation is far from being a national obsession in the UK, Charles Schwab, the leading online broker, claims that its UK customers traded 100 million shares in the company's first six months of operation in the country. Besides, if anyone doubts the average Briton's propensity for gambling and risk taking, just consider the success of the National Lottery.

Starky now holds nine stocks, at a cost of $19,000. He has had his losses, but overall he reckons he has made a net profit of $10,000 - a return of more than 50 per cent in nine months.

"I'm still not sure if I've just been lucky or if I've got some kind of talent for this," he says. "But for the time being I'm going with the flow. Maybe some day I'll do it full-time."

By the start of this year, there were some 5 million people in the US using the internet to buy and sell shares. That is a huge increase on the few hundred thousand who regularly dealt in the market via traditional brokerage houses five or six years ago. But with the numbers of Americans joining in the free-for-all rising by tens of thousands a week, the best estimates are for a total of 10 million by the end of the year.

They are catered to by about 100 online brokers, of which the top three - Charles Schwab, DLJDirect and E*trade - control nearly half the market between them. A few days ago the process of share democratisation went a big step further when Hambrecht & Quist, a San Francisco-based investment bank, began offering stock in initial share offerings directly to individual investors over the internet. Dropping the usual practice of allocating shares to favoured institutions at a set price, H&Q is using the Dutch auction method to sell shares. The highest bidders get the shares. William Hambrecht, the chairman, acknowledges that the move is deeply unpopular on Wall Street because it undermines the entrenched power of the big investment banks.

The growing power of the new online private investors, meanwhile, is indisputable. On any given day, the majority of trades in many smaller, more volatile stocks - particularly those of newly minted internet companies such as theglobe.com, run by Stephen Paternost and Tim Krizelman, or eBay - are in small lots of 200 or 300 shares. These, clearly, are the work of the new private investors. When the shares of such companies bounce up or down by 30 per cent or more in a single day, it is more often than not the private investors who are driving the move.

And when the professional dealers and investors of Wall Street shake their heads and mutter about a "bubble" in the internet sector, they blame it with considerable justification on the millions of new, private speculators.

"No way would I buy shares in a company like Amazon.com when its price earnings multiple is 400," says one professional. "This isn't investing, it's roulette. That's what these people out there in Peoria are playing every day."

Matthew Starky is, indeed, a rather mild example of the new breed of speculator. An increasing number of people trade professionally. They use facilities provided by specialised "day trading" companies, which allow the traders to use computers and special software in return for a fee or a cut of their profits. These places resemble the professional dealing rooms of Wall Street, with lines of earnest, sweating people hunched in front of computer screens scanning screen after screen of prices looking for the quick profit. Like the professionals, these amateur day traders often hold a position in the market for mere minutes at a time, trying to shave fractions of a percentage point of profit out of each trade.

You are likely to find out-of-work actors sitting next to retired civil servants, former stock brokers or young mothers who have taken up day trading because of the convenience of flexible working hours. They are old, young, middle aged, professional, blue collar. The only thing that seems to unite them is a massive appetite for risk - since almost all are betting their own money - and a boundless optimism about share prices.

Two factors are driving this explosion of private speculation. One is the internet. Online brokers have brought the commission cost of a share trade down from more than $100 to around $5. People can execute deals from their living room armchair and, thanks to the unlimited information now available on the net, they have an unprecedented amount of knowledge about the market.

The second factor is the bull market. As the longest bull market this century continues in the US, millions of people want to benefit. When prices keep rising, it does not necessarily take any special experience to make money. And the more amateurs join the market, the more prices keep going up, particularly in the favoured internet sector.

A lot of sheer ignorance and greed undoubtedly motivates many online speculators. On countless websites, people urge each other on in support of one stock or another, whipping up enthusiasm for it based on little more than a shared belief that the price will somehow rise. They concentrate heavily on high technology stocks and do not seem to worry about crazily high share valuations. "Buy high and sell even higher" seems to be their motto.

To save amateur investors from themselves, some online brokers no longer allow them to buy initial share issues without specifying limits. Others have slapped severe limits on the amount of margin they will allow traders, to prevent individuals ending up with excessive gearing on risky stocks. Even the regulators have weighed in. The New York Stock Exchange has told brokers, for example, to limit the way traders buy initial share offerings following some very heavy losses in the last few weeks. Alan Greenspan, the Federal Reserve chairman, warned traders that dealing in internet shares was akin to playing in a lottery.

Wall Street professionals like to dwell on the supposed lack of intelligence and experience of the new investors. Certainly, Wall Street is concerned at the spectacle of people risking money they cannot afford to lose on stocks they do not understand. But there is also genuine fear and bewilderment among professionals who can see the mystique, not to mention the profits, of their business being drained away as millions of ordinary people start trading for themselves. Stock market democracy is fast eroding Wall Street's traditionally lucrative role as middle man in the investment process.

Only one of the big online brokerages, DLJDirect (belonging to Donaldson Lufkin & Jenrette) is owned by an established Wall Street firm. The market leader, Charles Schwab, is a discount brokerage founded in the 1970s. Meanwhile, Merrill Lynch, the nation's biggest traditional broker, does not yet even have an online brokerage service.

But are the professionals right in dismissing the hordes of private investors as no better than gamblers who do not even understand what they are doing? It is easy to think so when you see the sky-high price of shares in companies with no profits and no prospects of profits - companies like Amazon.com which actually have a negative p/e ratio.

The truth, however, is not so simple. To begin with, the day traders are not always as ignorant as the professionals like to think. Look up a company such as Cendant, say, at a popular investor website such as Silicon Investor and you will find earnest and well-informed discussions about how its dividend or its share buy-back programme may affect the stock price. Online discussions of computer companies often revolve around highly technical details of hardware or software produced by the company. When it comes to information, many private investors are no longer very far behind Wall Street, if at all.

It is also worth remembering that when it comes to investing, the professionals themselves are not very good at it. Last year barely 15 per cent of US mutual funds beat the Standard & Poor's 500 index. It would be hard for the general public to perform much worse than that, even if it were trading blindfold.

Moreover, the day traders are simply doing exactly what thousands of young (and often quite inexperienced) professional dealers do for New York's established financial firms. Just like the amateur online traders, professional traders tend to buy and sell according to the feel of the market, often with scant regard to the real fundamentals of the companies whose shares they are buying and selling.

Every professional trader knows that the biggest dealing profits are to be made in the most volatile areas of the market. It is completely rational, therefore, for private traders to target internet and hi-tech companies where the very newness of the business is bound to create unusual volatility. It is also rational for them to choose a sector about which there is a lot of available information, thus putting themselves on an equal footing with the professionals. With supreme good sense, they tend to avoid secretive sectors such as banking where they know they probably cannot compete with Wall Street insiders.

What this means is that the sooner Wall Street drops its disdain for the common investor, the sooner the capital markets can adapt to make best use of this new participant. The new breed of private speculator is in general more intelligent, rational and informed than the professionals gives it credit for. Main Street USA has arrived in the stock market and intends to stay.

The paperback version of Richard Thomson's 'Apocalypse Roulette: The Lethal World of Derivatives' will be published by Pan on 12 March.