Overcome the Odds

I heard something remarkable this morning that reminded me just how ill-suited the human brain is for making investment decisions. The inherent decision-making deficiencies that we all share are well documented in decades of behavioral economics and behavioral finance studies, but we have reached a new low.

Bizarre Decision-Making Tendencies

According to one research study, investors are more likely to buy stocks that begin with their initials.  Really! We also are more inclined to buy products that begin with our initials.

Similarly, people named George are more likely (than random) to live in Georgia and people named Virginia are more likely to live in Virginia. One plausible explanation would be that parents living in Virginia (with a remarkable lack of creativity) could simply fail to come up with another name at the hospital.  "Why don't we name her Virginia, honey?" I could at least understand that, but the research indicated that people named George and Virginia actually moved to Georgia or Virginia. "Where should we move? I don't know; how about Virginia?" I could go on, but you get the idea. With this kind of track record, the odds are stacked against us when it comes to making rational decisions of all kinds, but especially investment decisions.

By the way, I did not make these examples up.  I heard about them in one of the Great Courses lecture series titled "Understanding the Mysteries of Human Behavior" by professor Mark Keary of Duke University. I am not affiliated with the Great Courses, but I highly recommend them to anyone looking to expand their knowledge. I watch one of the lectures every morning during my workout and they cover a wide range of subjects: math, history, science, psychology, religion, etc. The courses are taught by some of the top university professors in the country.

Follow the Rules

So how do we overcome the odds? We need to use an objective systematic investment process.  That might seem overly challenging for the average investor, but the systematic process does not need to be complicated.  In June of 2012, I wrote about an extremely simple systematic strategy that anyone could follow.  Buy when the monthly closing price of an equity index crosses above its 17-month moving average and return to cash when the monthly closing price of the equity index crosses below its 17-month moving average.

The article was titled "Take the First Step Toward an Investment Process." The strategy allocated 50% of equity to the S&P 500 index (SPX) and 50% to the NASDAQ 100 index (NDX) and significantly outperformed buy and hold investing with far less risk.

An increasing number of articles have recently raised the issue of a significant market correction. While an objective analysis of the U.S. Economy does not currently suggest an imminent recession, that does not preclude a significant market decline.  Unlike the SPX and NDX, the price of the Russell 2000 Index is hovering perilously close to its 17-month moving average.

Figure 1 below is a monthly chart of the RUT from early 2007 to 8/12/2014, provided by FreeStockCharts.com. As the name suggests, the website is free.  The latest value of the 17-month moving average was 1096.48 and the closing price on 8/12/2014 was 1133.03. A modest decline of only 3.23% between now and the end of August would trigger a return to cash for investors in RUT.

The red boxes in the chart indicated periods when the 17-month moving average would have signaled a return to cash.  The strategy would have avoided the drawdown associated with the Great Recession in 2008.  It would have returned briefly to cash in 2011 and 2012 and would have participated in the huge rally from 2012 to 2014.

Figure 1: RUT Monthly as of 08-12-2014

Figure 1: RUT Monthly as of 08-12-2014

Conclusion

Let's fact it, we are hardwired for failure.  Rather than ignore our inherent flaws, it only makes sense to take steps to recognize and overcome them. There are two main categories of investment strategies: discretionary and systematic.  Discretionary strategies are subject to all of the psychological and behavioral decision-making flaws and biases. Systematic or rule-based strategies are not.

Some traders have made the transition from discretionary to systematic trading strategies.  That is the good news, but I need to raise one important point.  Many of those traders have not formally evaluated the historical performance of their strategies. In other words, they are trading algorithmic strategies, but they do not know whether they have worked in the past.

Just because a strategy has generated attractive risk-adjusted historical returns is certainly no guarantee of future success, but it would be crazy to allocate capital to a strategy that has consistently lost money.  If you are currently trading an untested strategy, that could very well be what you are doing.

Systematic strategies do not need to complex to be effective.  Devote the time to developing and testing simple, systematic long-term strategies and it could greatly improve your performance and reduce your risk.

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Brian Johnson

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About Brian Johnson

I have been an investment professional for over 30 years. I worked as a fixed income portfolio manager, personally managing over $13 billion in assets for institutional clients. I was also the President of a financial consulting and software development firm, developing artificial intelligence based forecasting and risk management systems for institutional investment managers. I am now a full-time proprietary trader in options, futures, stocks, and ETFs using both algorithmic and discretionary trading strategies. In addition to my professional investment experience, I designed and taught courses in financial derivatives for both MBA and undergraduate business programs on a part-time basis for a number of years.
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