Investment special: Be very afraid

In The Fear Index, the latest thriller by Robert Harris, now heading for the Christmas bestseller lists, a brainbox hedge fund manager with little in the way of interpersonal skills discovers that his computer-driven trading system has flown out of control and threatens to send the world’s stock markets into a tailspin. Anyone familiar with Mary Shelley’s Dr Frankenstein will recognise the genre of the oddball genius consumed by his own creation — populist fiction at its best.

But is it fiction? Not so fast, reader. As Harris makes clear in a footnote near the end of his novel, the market meltdown which Dr Alex Hoffmann’s trading system appears to have prompted in The Fear Index is one that actually happened. A ‘flash crash’ on 6 May 2010 sent US stockmarket indices tumbling by more than 9 per cent in 15 minutes, causing short-term panic. One blue-chip company, Proctor & Gamble, saw its shares fall 37 per cent before they — and the market — eventually recovered.

What caused the flash crash remains a matter of controversy. As with the notorious ‘Black Monday’ crash of October 1987, when New York’s Dow Jones Industrial Average fell by more than 22 per cent in a single day, the flash crash was swiftly blamed on computerised trading programmes, and it was not long also before conspiracy theorists started to take issue with the somewhat inconclusive findings of official enquiries into how such an alarming episode could have come about.

In 1987 computerised trading was still in its infancy. There seems little reason now to dispute the verdict that a relatively new technique known as portfolio insurance was a powerful contributor to the market crash. Untested in a major market move beforehand, portfolio insurance was sold to institutional investors as a computer-driven risk management system, designed, ironically, to protect their portfolios against large market moves.