The main benefits of using a Trading System are to:
• Remove emotion from the buy/sell/hold decision.
• Remove personal ego from the buy/sell/hold equation.
• Exclude outside influences and ‘noise’ from the buy/sell/hold decision.
• Achieve objectivity & consistency, trust and confidence, in the buy/hold/sell decision process.
• Overcome personal expectations of the market.
• Overcome human biases that are detrimental to profitable active investment.
• Improve size and consistency of returns from your investment in the stock market.
With a correctly designed trading system you know exactly what your entry and exit criteria are and you can enter the market with trust and confidence that the trade will either be profitable or limited to a small loss. The word ‘you’ is highlighted above because you and you alone are responsible for all decisions that are taken in the market. Your broker, friends and the market are certainly not responsible!!!
Using a trusted, robust and consistent trading system will make you objective about your buy and sell decisions. What is meant by objective? The dictionary definition of objectivity is ‘uninfluenced by emotion, surmise or personal prejudice’ and that is precisely what you want in your trading decisions!
Making emotional trading decisions is probably the biggest reason why investors make losses, particularly large losses, in the market. The two main emotions that cause inconsistent buy and sell decisions are greed and fear – greed to make more profit and fear of making less profit, a large loss, of being proven wrong about your trading decision, or of missing out on a handsomely profitable trade.
Often traders will stay with a losing trade because they want to prove that the trading decision they made was the right one. More often than not this egotistical action will lead to losses. Being right is very important to human beings. However, active investment is about making money not about being right. Active investors have to learn that money can be made in the market even when the active investor is wrong as much as 50% to 70% of the time.
Naive investors also act on outside influences that lead to emotional illogical actions. These influences, which we call ‘noise’, include: brokers, ‘friends’, newspapers, newsletters, TV, chat forums and so called ‘experts’ who often have opposing views on the market. These outside influences will often convince the uninformed investor to take a position in the market because he/she does not have a consistent set of criteria against which to check whether the position should be taken. As a result, every position will probably be entered for a different reason.
The uninformed investor has inconsistent buy/sell criteria on which they act. If you don’t have a system then it will be easy for outside influences to impose their objectives on you. These will be different every time and will almost definitely NOT be consistent with your objectives……they will be consistent with the objectives of the outside influences. Even if the outcome of inconsistent decision-making is profitable it will unlikely be possible to repeat the positive performance in the future.
Taking action on emotions or ego and reacting to outside influences all lead to unpredictability and inconsistency in the buy and sell decisions that over time will cause sporadic large loss trades that erode or eliminate profits and that cause severe market under performance. It is these ‘outlier’ negative trades that need to be eliminated from your portfolio.
I have been trading with SPA since August, during which time my $100,000 investment has turned into a profit of $43,551 or an annualised compound return of 101%. Bearing in mind your ‘average’ return of somewhat less than 20%, does this mean I am heading for a fall? I would be concerned if the return were much less than your longterm portfolio’s average – should I also be concerned that for the past six months it is higher?
Response to Comment by Paul:
I’m afraid that it doesn’t work like that. As Mark Douglas’s 2nd Fundamental Truth states: “You don’t need to know what will happen next in order to make money in the market.” Why? Because it is impossible with any consistency to be able to tell what will happen in the future but you have to absolutely believe that with all of your being, not just say it.
This means that to be consistent you cannot make decisions now based on what you think may happen in the future. Human beings are constantly trying to work out what may happen in the future using any logic that they can lay they hands (heads) on! Such thinking takes us out of the now (using information before us right now) and enforces subjectivity based on conjecture and assumptions about what may happen.
We are trying to achieve objectivity & consistency and the only way that can be achieved is to use a decision support system (DSS) based on information at hand. The DSS must have been researched and have a known edge – that is what breeds trust.
So back to your question. What the market does will become known to us in time. If you decide to sell down now by taking profits prior to exit signals occurring, and the market does retrace and generate exit signals later, then you will have enforced an inconsistent action by going against your DSS (by the market confirming your action by doing what you thought it would). However, what will you do the next time you are in a similar situation? Break the rules of your DSS again. And what if the market doesn’t follow suit then and it rallies very quickly that causes a huge missed opportunity? What will your action be the follwoing time, and the one after that? Not following your DSS will guarantee inconsistency and subjectivity, the exact opposite of what you should be trying to achieve.
How well would a McDonalds outlet run if all the employees didn’t follow their processes that they had been trained to follow and decided what they thought was the right thing to do at every step of the way. Correct, inconsistent hamburgers and service which would lead to a whole lot of negative outcomes for McDonalds.
Actively investing in the market also requires tried and tested processes that deliver an edge over a large sample.
Regards
Gary
thanks to the author for taking his time on this one.