So many of us find it difficult to manage our investments without emotions of panic or anxiety that often lead to unsound financial decisions. This even applies to those of us who deem ourselves knowledgeable about the markets. That’s why systematic trading and investing can protect us from our own bad decisions.
Think about the time you have been faced with a decision to buy or sell a position, and sentiments of fear or notions of greed began to obscure your ability to make a decision in a rational and logical manner. We’re all driven by factors that often cannot be rationalized by data; “being human” can, unsurprisingly yet regrettably, get in the way of us making the best financial decisions for ourselves and our lives.
Writing in 1923 about the famous discretionary speculator Jesse Livermore, American author Edwin Lefèvre captured in a quote the fallibilities of human psychology when it comes to trading or investing in financial markets: “It is inseparable from human nature to hope and to fear. In speculation when the market goes against you — you hope that every day will be the last day — and you lose more than you should have had you not listened to hope… And when the market goes your way, you become fearful that the next day will take away your profit, and you get out — too soon. Fear keeps you from making as much money as you ought to.”
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What Do We Do When Bad Things Happen?
Edwin so eloquently captures one of the weaknesses associated with being human: our inability to remain calm in the midst of panic. What do so many of us do when the market is collapsing? We panic, we run, we exit.
Robert Carver, a portfolio manager for one of the world’s largest hedge funds, wrote that during the 2008 financial crisis, his team was terrified and considered liquidating all of their positions in global financial institutions. He described in his book Systematic Trading about how his firm “made over a billion dollars in a single day [because] our computer system had stuck to its preprogrammed set of trading rules and mechanically exploited the market moves almost to perfection, whilst [we] terrified humans had discussed [just the day before] closing it down.”
Another frailty of human psychology embedded within a large cognitive bias is overconfidence: We often believe that we are smarter than we are, that we have more knowledge about the trading system than we do. This overconfidence can propel us to make decisions on the basis that because we are smarter, we know more, and as a result, our decisions are more sound. This, however, couldn’t be further from the truth. The confidence that we have in our capabilities is often overestimated because we fail to take into account our greatest limitations.
Significant personal life events, such as divorce and separation, have also been shown to affect a trader’s performance. In the article “Limited Attention, Marital Events, and Hedge Funds” in the Journal of Financial Economics, the authors’ research concluded that in the years surrounding divorce, fund managers exhibited lower realized returns, their stock selection skills were poorer, their risk-adjusted returns deteriorated and were weaker compared to control samples. This evidence demonstrates the human frailties that make discretionary trading and investing so much more arduous to seek successfully and consistently over an extended period of time.
Emotions Can Get in the Way During Big Decisions
We humans are far superior to systems at tasks that require fundamental analysis and critical thinking, but what has been evident is that our emotions often hinder us from wholly and comprehensively utilizing the intelligence that is necessary to make sound trading decisions. The solution to this problem lies in systematic trading and investing. Putting in place a trading system eliminates the impulsive reactions and avoids the human behavioral biases that so many of us are prone to and makes it easier to commit to a steady and logical trading strategy.
Systematic trading and investing also institutes a commitment mechanism that prohibits the interference that may result from the cognitive biases that we as humans have. Instituting an objective trading system creates an omnipotent commitment mechanism. Such a system sets the line in the sand, delineates the rules, is backed by objective data and is a lever that puts just enough friction in place to disincentivize meddling, which produces more sound results.
A modern example of a commitment mechanism is given in Victor Niederhoffer’s book The Education of a Speculator, where hedge fund manager Victor has a large long position in silver futures. In the book, the Hunt brothers, who had been manipulating the market upward, are about to succumb to market events, which will cause the price to drop: “I decided to set my loss limit at 50% of my winnings. The model story on this point is Odysseus… I locked myself inside a racquetball court instead of tying myself to a ship’s mast. I issued instructions to my assistant and future wife, Susan. ‘Do not listen to my entreaties if I wish to double further. If the losses reach 50% of the winnings, reduce my positions by one-half. If I beg to be released, sell everything out’... Some rumors about liquidation by the Hunts had hit the fan… I immediately placed a call to Susan, ‘Untie me, disregard everything I said before.’ ... My faithful companion followed my original directions.”
Susan, Victor’s partner, was the commitment mechanism. She closed the entire position, and Victor went on to continue his journey. Not all of us have a Susan, so a trading system helps ensure that we remain committed to the goal at hand.
Systematic Trading Lets Traders Better Manage Risk
Instituting a systematic trading approach permits traders to be more disciplined in managing risks, as an appropriate risk-management framework can be constructed within the trading strategy itself, rather than being treated as a side note. The trader can apply or operate within a stated level of risk or permit variation of risk within a specified range. Statistical techniques permit traders to determine with a reasonable measure of accuracy volatility forecasts, both in the short and midterm, enabling them to adequately ensure risks are within an approximately limited band. The trader can use conscientious statistical methods to ensure a sound risk-management framework.
Together with utilizing scientific methods to gauge volatility, systematic trading enables limits to be posited and observed in order to control risks and exposures. Upon these limits being reached, position sizes can be automatically capped or minimized.
Systematic Investing Has Produced Better Performance
There is countless research done on the performance of systematic investing vs. discretionary investing. Such research has evidenced that systematic investing often generates far higher performance and is more consistent than discretionary investment. In the Journal of Alternative Investments, researchers concluded that systematic-trend-following fund managers had higher returns and better performance than other categories.
Similarly, researchers from the Man Group analyzed the performance of systematic and discretionary managers, and their research concluded that systematic macro funds outperformed discretionary macro funds.
Systematic Trading and Investing Is Accessible
For those beginning their journey into the capital markets, it is easier than ever to trade or invest in a systematic way. There are a host of global retail brokerages, such as Quantfury, that make it easier for users to submit orders automatically via mobile applications, making fully automated trading a possibility. Moreover, data, such as historical prices, company research and news reports, can be easily downloaded online at no cost from various websites.
Systematic trading and investing allows users to make investment and trading decisions in a methodical way, with a high degree of ease.
Luke Brindle and Daniel Schwartzkopff contributed to this report.
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