There's only one way to leave your emotions out of investing: algorithms
June 27th, 2019
Do you know what the average amount of time a user spends on a webpage? 15 seconds. If you narrow down the filter from webpages to articles alone, one in three readers spends less than 15 seconds reading what they originally thought was valuable enough to originally click on. That means that I have five seconds before I lose one-third of my audience who is reading this... And we have officially lost them, back to the infinite abyss in today’s age of immediate gratification.
Equipped with a supercomputer in our palms, we are constantly flooded with an influx of information while browsing search results, social media, or simply reading the news. As our eyes wander without intention, we are naturally drawn to narratives which paint a negative world view, and in many cases our negative reactions can stir up some unpleasant emotions and even prompt us to react based on those feelings (just look at the comment section on any opinion piece). When it comes to investing, our vulnerability to negative news peaks with headlines surrounding market volatility and investor panic.
As I discuss in the research paper, “Unemotional Investing: a Case for Modern Algorithms,” while dramatic news regarding the markets may bring about an emotion that feels like fear, it’s something quite different. Fear is the unequivocal human response to a direct threat, and since the markets do not threaten anyone physically – setting into motion that true fight or flight response – we know it’s something else. Instead, that feeling of panic is anxiety, an ongoing response to what might happen, which prompts questions like “What if?” or “I should have…” or “Why didn’t I get out earlier?” or “How could I have done things differently?”
A great example of anxiety impacting investment outcomes is Dalbar’s annual Quantitative Analysis of Investor Behavior. It shows the annualized rate of return of the S&P 500 over the past 30 years is just above 10 percent – despite suffering through repeated recessions.
By contrast, the annualized rate of return for an all-equity mutual fund investor was less than 4 percent. This suggests that the anxiety of experiencing losses may create more losses than recessions.
The problem is, anxiety is a human emotion that demands action. So, when the stock market plummets, investors may feel compelled to go on a selling spree. What’s important to understand is, unless an investor plans on spending his or her portfolio that day, there is little immediate reason to worry.
What can you do?
Algorithmic approaches to asset management have several benefits, which cut down on emotional responses that can ultimately reduce wealth creation.
- Algorithms are rule-based. This decreases the anxiety of not knowing what the strategy will do in a given situation.
- Algorithms consistently execute the strategy even when times get tough. This reduces anxiety related to the fortitude of the financial advisor.
- Algorithms see a bigger picture through analyzing data sets larger than what humans can manage. This cuts down on anxiety related to whether enough information is known to make a complete decision.
In short, algorithms can help give investors confidence, which allows investors to relax. Quantitative models can also enable financial advisors to spend less time worrying about the asset management approach and more time working with clients and prospects during periods of volatility.
A closer look
Helios Quantitative Research specializes in the development of compound-efficient, “responsive” algorithms for use in the retail asset management space. “Responsive” modeling requires the use of facts (not guesses) before meaningful changes are made.
An example of our “responsive” design was in February 2018, when many fund families heavily de-risked their strategies over fears of the North Korean nuclear standoff. Our calculations recognized the market downturn was anxiety-based and was not supported by hard facts in the economy or markets. As a result, we were able to stay overweight equity markets and seek enhanced compound efficiency.
Want to learn more about algorithms and their place in investment strategy? Read my research paper, “Unemotional Investing: a case for modern algorithms.”