Mechanical Investing Not A Golden Key

By Andrew Beattie AAA

Someone in the world has a golden key with your name on it. Once you take the key, after paying them a small pittance, of course (it is a golden key after all, you don't just give those away), you can unlock the doors to infinite wealth. Unfortunately, most key buyers find a massive dragon wrapped around their piles of wealth, fitfully snoring away. The topic of investment programs has been weighed and measured by many people, and the findings are often split into "This Works!" (buy my book) or "This Doesn't Work!" (buy my book).

These investment programs generally adhere to a mechanical investing strategy, in which stocks are bought and sold based on predetermined criteria. Although this method removes some of the danger of investor emotion in trading, it also has many pitfalls.

Night and Day
To begin, let's look at programs in general. Most are loosely based on the efficient market hypothesis, which essentially states that the market accurately reflects all the known and relevant information currently available. In brief, prices are "right" and any changes in price that may occur in the future are impossible to accurately predict without a time machine. Where mechanical investment strategies diverge from EMH is in how quick the efficient market is. Although they believe that the market is largely efficient and self-correcting, they also believe that the time lag between inefficiency and correction is enough to take a position and profit off of arbitrage. (To learn more, read What Is Market Efficiency and Working Through The Efficient Market Hypothesis.)

It all comes down to how efficient you think the market is. Warren Buffett, one of the world's great investors, examined the efficient market hypothesis in his 1988 letter to the shareholders of Berkshire Hathaway. Observing correctly that the market was frequently efficient, Buffett points out that academics and investment professionals went on to conclude - perhaps incorrectly - that it was always efficient. The difference between these propositions is night and day.

There is no doubt that Buffett's billions add some weight to his words. And they should, because that fortune was built on looking for undervalued companies that have been mispriced by the market. However, while there is little doubt that Warren Buffett has made huge profits from identifying underpriced companies and holding them, he doesn't deal in the same short-term arbitrage that mechanical investing goes after. Even so, the level in which Buffett is outperforming the S&P 500, while still impressive, has been in decline as the market gets tighter and information faster. (For more insight, read Warren Buffett: How He Does It.)

The Dragon's Lair
The efficient market is the dragon atop the pile of golden arbitrage. Arbitrage, "riskless profit", is an accidental pricing discrepancy in the market. Imagine two companies that are identical in every way, including the amount of revenue generated per period and the types of products sold. Now, one of these companies is selling for $20 per share and the other is selling for $23 per share. These companies are identical so according to the EMH, the market will take that into account and bring the two prices to a merging point (convergence).

The ways an investor can take advantage of this delayed correction are numerous. Usually it involves leverage, in which an investor places a bet that the market will correct itself and multiplies this bet by borrowing more money to put toward the wager. Trading programs are mathematical bookies that tell you about the latest race (discrepancy) and give you the odds (historical data and extent of the discrepancy). Unfortunately, just as a bookie can spoil a bet by telling too many people a hot tip, so can a trading program. When a particular program becomes used widely enough, it renders itself impotent and sometimes dangerous.

A program, whether on computer or a book about a certain method of mechanical investing, is like a narrow tunnel past the dragon. It's safe enough when it's just you in the tunnel, but when enough people are using it, the EMT dragon is going to hear the footsteps and clear the place out. For example, when famed investor Peter Lynch started cashing in tenbaggers, it seemed like he could do no wrong. But, as more and more people started looking for stocks like he did (thanks to his book), the market started ratcheting up the prices on potential tenbaggers, cutting into the availability of quick profits. (For more insight, see The Greatest Investors and Pick Stocks Like Peter Lynch.)

Dragon Slayers?
Profiting from arbitrage can still be possible, especially if you have huge amounts of capital. It is quite common for hedge funds to place large bets in all sorts of arbitrage positions to eke out profits wherever they can. Rather than slay the EMH dragon, a hedge fund's actions often alert it to the smaller investors sneaking around its tail. Even hedge funds get burned, although they can handle it better than an individual investor.

Playing with Fire
The tunnels around the dragon and straight to the gold are getting narrower and fewer as the market continues to mature. Using trading programs or mechanical investing strategies can still lead to profit, but the returns are shrinking and the time frames in which buy and sell decisions have to be made are getting smaller. Computers running trading software have kept mechanical investing alive, but it is only a matter of time until conservative strategies become more attractive. (For more on trading systems, read Trading Systems Coding.)

There is never going to be a 100% foolproof way to make a profit. Even indexing will tempt the EMH dragon's wrath if enough of the market turns to passive investing. This is because indexing encourages people to ignore everything but the companies listed on the S&P or other indexes, just like trading programs eliminate everything but a few choice metrics. The difference is that mechanical investors only hurt themselves, whereas passive investors have the potential to cause a large bubble and damage the overall market. If enough people quit thinking, the opportunities for mass stupidity go up exponentially.

Taking the Long Route
Investment strategies like value investing succeed because they are long term and vaguely defined. Even if Warren Buffett wrote the definitive book on value investing that laid out the acceptable limits for each metric and turned it into a program, it would lessen the profits earned from all investors following the value investing strategy only slightly because it is a buy-and-hold strategy. The same goes with value averaging, most contrarian strategies, and so on. When you stretch out any investment, you lessen the impact of market volatility and give yourself more time to make buy and sell decisions. In essence, you are avoiding the dragon's lair entirely. For most people, it is better to buy investments you want to keep and let others get burned while trying to run off with the gold.

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