What Is Mechanical Investing?
Mechanical investing is any one of a number of ways of buying and selling stocks automatically or according to pre-set criteria or triggers. The primary purpose of this approach is to remove as much human emotional behavior as possible. Emotions will often negatively impact or cloud rational investment decisions.
A systematic investment plan can also be partly based on factors that an active investment manager applies, but it is mostly intended to be implemented on autopilot.
- Mechanical investing refers to investment strategies that are based on predefined rules or criteria.
- These can include automatically investing a certain portion of earnings into a retirement plan on a monthly basis, buying or selling shares when pre-set price triggers are reached, or using a roboadvisor, among others.
- The goal of any mechanical investing method is to remove the influence of emotion and psychological biases.
How Mechanical Investing Works
Mechanical investing can take many forms. It can be as simple as a set dollar or paycheck percentage amount into a 401(k) account, for instance, or a commitment to buy a stock when its valuation falls to a certain price-to-earnings ratio and sell it when the valuation hits a higher predetermined level.
Valuation markers are common in mechanical investing, but technical analysis may also inform an automated approach to investing. Moving averages, whether simple or exponential, 50-day, 200-day, or another time period, can serve as triggers to buy or sell stocks. The Relative Strength Index (RSI) or the Moving Average Convergence Divergence (MACD) are two other popular signals upon which a mechanical investor sets trading orders.
Whatever criteria are used by the investor, the idea is to remove subjective feelings and second-guessing from trading stocks (or other securities) and stick with a disciplined approach. Mechanical investing can be considered akin to passive investing, whereby money is normally put to work consistently over time, but at least some sort of thought-out criteria is applied.
Examples of Mechanical Investing Strategy by Name
One of the most common mechanical investing systems is called the Dogs of the Dow. This strategy involves buying the 10 stocks on the Dow Jones Industrial Average with the highest dividend yield at the beginning of each year. These high dividend yields generally result from poor or lagging investment performance from the prior year. The expectation is that the stocks will show mean-reversion over the coming year. The portfolio is adjusted each year to only include the 10 highest yielding stocks. Proponents of mechanical investing say that using this method of investing, like other pre-set strategies, removes human biases that often derail rational investment behavior.
Another type of mechanical investing is to hand over all investment decisions to an algorithm that follows a pre-defined strategy such as modern portfolio theory (MPT). Roboadvisors are a class of automated investment advisor app that does exactly this and for a fraction of the cost of a human financial advisor or portfolio manager, who may make human errors or be swayed by emotions like fear and greed.