How Systematic Trading And Investing Overrides Bad, Emotional Decision-Making

* By Dr Iyandra Smith Bryan, the Chief Operating Officer at Quantfury Trading Limited

In this article we see how sophisticated trading software is saving traders in The Bahamas and elsewhere from falling victim to their own dark urges and human frailties. The results are often spectacular.

o many of us often find it difficult to manage our investments without emotions of panic or anxiety leading us to make unsound financial decisions. This even applies to those of us who consider ourselves knowledgeable about the markets. Think about the time when you had to decide whether to buy or sell a position, when sentiments of fear or notions of greed began to obscure your ability to make a decision in a rational and logical manner. We are all driven by irrational factors; “being human” can, unsurprisingly yet regrettably, get in the way of us making the best financial decisions for ourselves and for our lives.

THE PROBLEM: HOW CAN WE PROTECT OURSELVES FROM OUR OWN FRAILTIES?

Writing in 1923 about the famous discretionary speculator Jesse Livermore, the American author Edwin Lefèvre described the fallibility 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.”

SHe wrote in his book Systematic Trading: “After yet another crisis meeting, where we decided to take no action for now, I left the meeting room and returned to my desk. As I sat down, a colleague came over and started typing on my keyboard...He pressed return and a live estimate of today’s profitability appeared on my screen. For the first time in our firm’s history it showed a ten-digit number. We had made over a billion dollars in a single day. Our computer system had stuck to its pre-programmed set of trading rules and mechanically exploited the market moves almost to perfection, whilst terrified humans had discussed closing it down.”

Another human frailty is overconfidence. We often believe that we are smarter than we are and that we know more about the trading system than we do. Very often, however, this could not be further from the truth.

Significant personal ‘life events’ such as divorce and separation have also been shown to affect a trader’s performance. In an article entitled Limited attention, marital events and hedge funds in the Journal of Financial Economics, the authors’ research concluded that fund managers generated lower realised returns in the years before and after their divorces. Their stock-selection skills were poorer and their risk-adjusted returns deteriorated and were weaker than those of control samples. This is evidence that human frailties make discretionary trading and investing so much more arduous over an extended period of time.

THE SOLUTION: SYSTEMATIC TRADING AND INVESTING

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 at one of the world’s largest hedge funds, wrote that his team was terrified during the financial crisis of 2008 and thought of liquidating all its positions in financial institutions all over the world.

We humans are vastly superior to IT systems when we perform tasks that require fundamental analysis and critical thinking, but our emotions often hinder us from using the intelligence that we need to make sound trading decisions. The solution to this problem lies in systematic trading and investing. When we put a trading system in place, it eliminates impulsive reactions and cuts out the human behavioural biases to which so many of us are prone. It also makes it easier for us to pursue a steady and logical trading strategy.

System trading and investing also institutes an omnipotent ‘commitment mechanism,’ backed by objective data, that prohibits the interference that may result from the cognitive biases that we humans have. It draws a line in the sand, delineates the rules, causes just enough friction to disincentivise meddling, and produces sounder results.