Writing in 1923 about the famous discretionary speculator Jesse Livermore, the 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.” 

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 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 preprogrammed set of trading rules and mechanically exploited the market moves almost to perfection, whilst [us] 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 than we do. In this digital age, we can find ourselves bombarded with information and opinions from news outlets, social media, and chat forums that can ignite our FOMO - fear of missing out - and motivate our decisions.

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 can motivate decisions and impact the results of discretionary trading and investing.

While humans are far superior to systems and tasks that require fundamental analysis and critical thinking, what has been evident, however, is that our emotions play just as significant a role in our decision making. 

When it comes to trading and investing, the solution to this problem lies in a systematic approach. Implementing a trading and investing system eliminates impulsive reactions and avoids cognitive biases, making it easier to commit to a consistent and logical strategy that can optimize results. Here’s what you should know about implementing these systems.

Instituting a systematic trading system creates an omnipotent commitment mechanism. Such a system sets the line in the sand, delineates the rules, and is backed by objective data. It’s 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 “Education of a Speculator,” where a hedge fund manager Victor 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, 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, who 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 provides traders with a transposable groundwork for trading that can be better managed from a risk perspective.

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. 

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 ample research on the performance of systematic investing versus 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 easily and methodically make investment and trading decisions that take emotions out of the equation.