Why it’s dangerous to rely on mechanical trading systems?
What Is Mechanical Investing?
Mechanical trading systems or just mechanical investing is any one of a number of ways of buying and selling stocks according to pre-set criteria or triggers. The primary purpose of this approach is to remove as much human emotional behavior as possible. Emotions will often negatively impact or cloud rational investment decisions. A systematic investment plan can be partly based on factors that an active investment manager applies, but it is mostly intended to be implemented on autopilot.
How Mechanical Investing Works
Mechanical investing can take many forms. It can be as simple as a set dollar or paycheck percentage amount into a 401(k) account, for instance, or a commitment to buy a stock when its valuation falls to a certain price-to-earnings ratio and sell it when the valuation hits a higher predetermined level.
Valuation markers are common in mechanical investing, but technical analysis may also inform an automated approach to investing. Moving averages, whether simple or exponential, 50-day, 200-day or another time period, can serve as triggers to buy or sell stocks. The Relative Strength Index (RSI) or the Moving Average Convergence Divergence (MACD) are two other popular signals upon which a mechanical investor sets trading orders.
Whatever criteria is used by the investor, the idea is to remove subjective feelings and second-guessing from trading of stocks (or other securities) and stick with a disciplined approach. Mechanical investing can be considered akin to passive investing, whereby money is normally put to work consistently over time, but at least some sort of thought-out criteria is applied. Full Story
Technical indicators or Fundamental Analysis
Individuals, especially novice plays are always lead astray when it comes to Technical indicators and trading. One school pushes technical indicators, while the other school pushes for fundamental analysis. In an abstract way, fundamental analysis is nothing but a mechanical system in disguise. The data is provided in a standard manner, and so anyone can decipher it with almost no effort. Mechanical trading systems put forth a set of rules; all one has to do is follow these rules. In essence, everyone following this rules could arrive at the same conclusion.
The paradox theory states that one will get exactly the opposite of what one chases. The same holds true in the arena of technical indicators and trading. Be realistic and do not assume that these indicators alone will always keep you out of harm’s way. We all know that at any given time the masses must lose to be able to feed the big players. That’s why the 90/10 ratio has almost seen no variation over the decades. 90% represents the percentage of losers and 10% the proportion of winners. Hence, it is important to understand the basic principles of basic portfolio management before committing money to the financial markets.
Technical Indicators can work but the system should not be fully mechanical in nature
We could go on into great detail about why mechanical trading systems almost always fail, but the theme would be the same. So in the interest of keeping you awake, we will keep it short and sweet. Let’s just pause for a second here and investigate the name “Mechanical.” One of the definitions by Merriam’s Webster online dictionary is “done as if by machine: seemingly uninfluenced by the mind or emotions.”
Notice the key words here uninfluenced by the mind or emotions. First of all the market is nothing but a composition of a million minds. Using a system that’s based on the rules set forth by one man’s mind and worse still devoid of any mental influence is a recipe for disaster. Secondly, the marketplace is nothing but a sweat pool of emotions; lust, greed, power, hate, fear, etc. swirling through the markets like a hurricane. Technical Indicators should be part of your trading strategy but it should not base your entire strategy on technical analysis.
Trading Indicators and even best Mechanical trading systems do not work forever
It’s virtually impossible for a mechanical system to last forever since by designing anything mechanical must and will break down at some given point in time. It’s rather amusing the terms we chose to represent the things we use or to define what side of the markets we are on. It’s almost as if we have nothing but a secretly programmed desire to lose syndrome ingrained deep with our psyches. Bullish and bearish, we choose two of the most stupid, dumbest, irrational and easily angered animals to represent whether we think the market will go up and down.
Then if we happen to be individuals that favour just one sector we come up with the term bugs as Internet bugs or gold bugs. Why such a disgusting animal to represent one’s position and views. As we all know most humans react in an adverse way to bugs, the first thought that springs to mind are to crush them.
Even examining the language we use in the marketplaces illustrates further psychological issues; scalp, plunge, up thrust, perfect bottom, down thrust, flip, climactic sell-off, etc.
The worst part of all this is that we pass nothing new to the next generation. We just reinforce these Neanderthal views, in fact branding them into the next generations memory more aptly describes the process. Is it any wonder then that we keep repeating the previous generation’s mistakes? Moreover we do so in a much more grandiose manner. Just look at the speculative phase we have entered now (credit bubble, real estate bubble and so on) it makes all the mistakes our ancestors made pale in comparison.
We leverage ourselves to our necks with debt to buy goods we don’t need and use the money we don’t have to pay for them. The real estate bubble is one classic example of madness and history repeating itself on a gigantic scale. Individuals take home equity loans against the rising values of their homes and use this to finance their extravagant lifestyles. Is there anything more insane, taking credit to buy something more on credit?
Getting back to the topic at hand; no one is taught to look at the markets as a game and study the mass mind and behaviour of individuals. After that one can go about trying to master a few Technical Analysis tools that are open to subjective interpretation. By personal interpretation, we are referring to the statement that “beauty lies in the eye of the beholder.” Each should see something different when using such an indicator. This TA tool must never be allowed to become standardised. If it is, the end is near. The ones that learn to correctly master this tool will come out ahead. However since the method is not available in a standardised format, this system could work almost indefinitely.
In the end, mechanical trading systems are reflective of our lifestyle and the way we are as a group of individuals; the 9-5 rat race and the zombie-like a nation where everyone thinks and acts like one. A mechanical system is also reflective of the fact that most of us do not want to think, we want everything handed down to us and when we get whacked on the head we cry like babies. It is, for this reason, we never seem to learn from history but only look for ways to perpetuate the same mistakes on a colourful style. The only way to break from this way of thinking is to attempt to start thinking and using your mind.
There is nothing wrong with making a mistake because you might learn something as a result of one; perpetuating someone else’s mistakes provides no clues for improvement but only rules for self-destruction.
Customization is the key when it comes to using Technical Indicators
At the very least some customization should be attempted so that the system is adapted to one’s needs. It amazes me that the easiest and most efficient system in the world is not studied or followed more widely. The system I am referring to is trend analysis; all you do is spot a new trend and stay on board till the trend ends. Trend analysis involves the drawing of simple lines; it takes a little practice but is worth its weight in platinum.
When using Technical Indicators, it is best to use ones that are not widely followed or if you are using Technical indicators that are widely followed then you should consider adjusting the parameters.
So let’s look at what type of system can and will work in the markets. First of all, one has to understand the difference between contrarian investing and investing based on Mass psychology. Contrarian investing is a very simple system as it involves taking a position against the masses. Mass psychology measures the frenzy periods or times of extreme hate or disgust towards a particular sector or sectors, and then a position is taken during these desperate times.
Furthermore, Mass Psychology measures the level of euphoria in the camps of those that believe in the investment.it will measure how many of the so-called contrarians are now extremely bullish and euphoric in a given sector. In most cases when a contrarian takes a position in a particular industry, he is doing so as a counter move to what the masses are doing. However, the majority of the contrariansare still nervous and keep checking their positions rather frequently to make sure that at the very least the bottom is in.
Once the sector starts to take off and produce returns they lose this nervousness and become very bullish; in other words, they have now entered the euphoric phase. This is where mass psychology kicks in. At this point it will be time for the smart investor to bail out, you may not be selling at the top, but you will be pretty close to it.
So understanding mass psychology is an important and integral part of a trading system. Secondly, one should master several technical Indicators in order to improve your technical analysis of the Financial markets. Thirdly you need to understand be patient and disciplined. You have to understand that sometimes you might have to wait for months on end before you can take a position. However, you could be rewarded in weeks for your patience.