In this article - written by Dr Iyandra Smith Bryan (pictured below right), the Chief Operating Officer at Quantfury Trading Limited - we see how sophisticated trading software is saving human traders in The Bahamas and elsewhere from their own dark urges and frailties. The results are often spectacular.
So 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 deem ourselves knowledgeable about the markets. Think about the time you have been faced with a decision 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 captured 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."
Fear keeps you from making as much money as you ought to
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 financial crisis of 2008 his team was
terrified and considered liquidating all of its positions in global financial institutions. He wrote in his book Systematic Trading: "After yet another crisis meeting, where we decided to take no action for now", despite the portfolio managers feeling that it would be best to make some decision, Carver returned to his office the next day and "for the first time in our firm's history... 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, while [we] terrified humans had discussed [just the day before] us closing it down."
Another frailty of human psychology embedded within a large cognitive bias is overconfidence. We often believe 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 theory that because we are smarter, we know more and, as a result, our decisions are more sound. This, however, could not be further from the truth. The confidence that we have in our capabilities is often too great because it fails to take into account one of our greatest limitations.
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 surrounding their divorces. Their stock-selection skills were poorer and their risk-adjusted returns deteriorated and were weaker when compared with 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
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.
Divorce and separation have been shown to affect a trader's performance
System trading and investing also institutes a commitment mechanism that prohibits the interference that may result from the cognitive biases that we humans have. When we institute an objective trading system, we create an omnipotent commitment mechanism. Such a system sets a line in the sand, delineates the rules, is backed by objective data, is a lever that puts just enough friction in place to disincentivise meddling, and produces sounder results.
A modern example of a commitment mechanism is to be found in Victor Niederhoffer's 1998 book, Education of a Speculator, where Victor, a hedge fund manager, has a large long position in silver futures. In the book, the Hunt brothers, who had been manipulating the market upwards, are about to succumb to market events that 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 rumours 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, in other words, provides traders with a transposable groundwork for trading that can be better managed from a risk perspective.
Systematic investing often generates far higher performance than discretionary investment
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 a variation of risk within a specified range.
Statistical techniques permit traders to determine volatility forecasts with a reasonable measure of accuracy, both in the short and medium term, enabling them to keep risks within an approximately limited band. The trader can use conscientious statistical methods to evolve a sound risk-management framework.
Together with the use of scientific methods to gauge volatility, systematic trading allows 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 minimised.
Systematic investing has produced better performance
Countless research has been done on the performance of systematic investing versus discretionary investing; it has shown 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 those in other categories.
Similarly, researchers from the Man Group analysed the performance of systematic and discretionary managers and concluded that systematic macro funds outperformed discretionary macro funds.
Systematic trading and investing is accessible
For those beginning their journeys 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 easy 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 downloaded from various websites easily and at no cost. Systematic trading and investing allows users to make investment and trading decisions in a methodical way, with a high degree of ease.
* Article By Dr Iyandra Smith Bryan, the Chief Operating Officer at Quantfury Trading Limited.