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Why Trade Systems?
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I am often amazed at the
unbelievable amount of worthless investment advice offered. The reason
I say that is because the vast majority of advice offered seems to be
nothing more than opinions based on little to no real scientific
research. Its similar to the countless “cures” that you can find in
health food stores. Nothing more than untested and unsubstantiated
claims. My opinion on this continues to get
stronger and stronger over the years. I have tested countless methods
that the authors purported to be “money makers” only to see the vast
majority of these ideas being nearly worthless. Many of these authors
are very respected and have well established followings. In some cases
they have near celebrity status! A good example of this is Chart
Patterns. There is an entire industry built on chart patterns. Things
such as triangles, pennants, rising wedges, trend lines etc etc.
Unfortunately, if you ever try to code these patterns you will first
find that patterns are extremely subjective. A hundred people looking
at the same chart will see 100 different patterns. In addition, most
“obvious” patterns are only obvious after they have confirmed
themselves. This is nothing more than hindsight bias. When you put the
rubber to the road and actually test many of these “chart patterns”
they don’t hold up at all. I find the same true for things such as Gann
Lines, Fibonacci numbers, Elliot wave, the list goes on and on. Think about this, you wouldn’t put
a powerful drug in your body that was not first rigorously tested in a
scientific manner would you? Why would you expose your financial health
to ideas that were not also rigorously tested in a scientific manner?
It’s amazing the financial advice and "tips" people will take based on
the flimsiest of evidence! This was hammered home recently with all the
multimillion-dollar salaried Wall Street analysts who lost their
investors billions. In some cases this was disingenuous advice, in
other cases it was just stupid predictions based on untested theories
about what “should” happen. "Looks like a cup and handle base"???? What I am suggesting is that the
ideas you use should be ones that have gone through rigorous scientific
analysis. Ideas that have been broken apart in hundreds if not
thousands of different ways and then tested across thousands of
different examples to see how they would have performed. Furthermore,
trading good systems can help to reduce the psychological sabotage so
prevalent when trading without a mechanized method. The demons of fear
and greed and panic and euphoria can be kept in check better. The following text was taken from a
popular trading book, Decision Traps, by J. Edward Russo and Paul J.H.
Schoemaker. In this book, nine different types of decisions were tested
using three different decision methods. The accuracy of the decisions
was then compared and analyzed for effectiveness in predicting final
outcomes. The investigator looked at different types of decisions,
predicting grades, predicting recovery from cancer, performance of life
insurance salesmen, as well as predicting changes in stock prices. He
used three different decision making processes: an Intuitive Prediction
Model, a Subjective Linear Model, and an Objective Linear Model. Decision Models
Intuitive
Prediction Model (Discretionary Trader) Intuitive prediction is defined as
making a decision without the use of any objective or quantifiable
data. For instance, in trying to predict the academic performance of
graduate students, the researches asked their advisors to do so without
seeing their grades and just by talking to them. The decision-makers
had to rely on their intuitive impressions and any other factors they
thought relevant (how the student dressed, their language skills,
grooming habits, etc.). This is the same way discretionary traders make
trading decisions - using intuition and gut instinct. In predicting the
stock prices, it is highly likely that the researcher engaged a
discretionary trader to predict the future prices of stocks. Subjective Linear Model
(Technical Trader) A Subjective Linear Model is a much
more complex decision making process. It starts with the interviewing
experts in a field and learning how they make decisions. The researcher
literally asks the expert how he or she makes decisions and they
respond by explaining how they make their predictions. Although these
experts are not using quantifiable data, they have enough experience
and knowledge in their field to be successful. This decision making
process is then outlined by the researcher. For instance, a physician, highly
experienced in treating cancer, has probably become fairly adept at
predicting the life expectancy of his patients, even without using any
objective data. The researcher interviewed the physician and attempted
to determine exactly how the physician made this assessment. Then the
researcher put this newly quantified data into a regression model and
attempted to predict the life expectancy of cancer patients. This is very similar to how a
technical trader makes decisions. He goes to seminars and reads books
to learn how the experts make decisions using technical indicators. He
then takes what he learns and attempts to trade like he experts. In a
sense, he does his own regression model of the expert's process to make
trading decisions. Objective Linear Model (System
Trader) For the Objective Linear Model, the
researcher developed an objective model based on historical tests and
observations to predict results. This is defining and using
quantifiable data, running historical tests, and then using the results
of the tests to predict future outcomes. For instance, the researcher would
look at reams of physical data from terminal ill patients, and
correlate the data with how long the patient lived. After running the
historical tests, the researcher would then obtain the physical data
form cancer patient, and using the historical test data, attempt to
predict how long that cancer patient will live. This is exactly what a system trader does. He runs historical tests and then uses that data to take a position in the market. He uses objective quantifiable data tested historically to make his trading decisions. The following table shows the results of tests.
In every case, the Subjective
Linear Model outperformed the Intuitive Prediction Model bit only by a
small margin. If you look at predicting the changes in stock prices,
the Subjective Linear Model only slightly outperformed the Intuitive
Prediction Model. |
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September and October 2003
articles
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a must read!
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