Seeking Alpha
, Think Finance (588 clicks)
Long/short equity, arbitrage, event-driven, research analyst
Profile| Send Message|
( followers)  

We live in an increasingly centrally-planned market. There is no if or but about it. Federal Reserve officials up to and including Ben Bernanke have stated that an objective of quantitative easing policies ever since November 2008 is the inflation of assets. Thus, a stated objective of monetary policy is to manipulate prices on such things as long-dated treasuries or even stocks. The purpose of this is to give rise to a wealth effect which should lead to more economic activity.

The artificialization of markets, I won't hide it, took a toll in my ability to predict them. For a while, the fundamentals told of a given direction, and the outcome - dictated centrally - ended up being another. I was thus forced to find ways to cope with this new reality. This article is about those ways. This article basically presents 2 ways to take yourself - and thus any possible rationality - out of the investment loop, so as not to be affected by what might be arbitrary decisions to set market direction, and if possible to profit from them.

Indexation

Using index funds is perhaps one of the oldest ways to take yourself out of the loop. You just buy an index, and hope that the long-term drift up will provide the returns. This alone can already be enough to beat around 80% of the actively managed mutual funds out there. Likewise, it should be enough to beat most of the traders as well.

Today, buying an index fund is made even easier by the emergence of ETFs (Exchange Traded Funds), which trade like shares. You can quickly buy the S&P 500 buy buying the SPDR S&P 500 (SPY) or the Nasdaq 100 by buying the PowerShares QQQ (QQQ). By doing so, you'll have access to low management costs, good tracking error and, when trading, low spreads and large liquidity.

Indexation is particularly well-suited for a market where the monetary authorities have taken it as their mission to inflate the very indexes you're investing in. It's also the kind of investment which can easily and quickly be dumped once these authorities decide their manipulation is no longer required.

Automated trading

Another alternative - and one in which I myself invested significant time - is to automate your trading. That way, you will no longer be biased by your own opinion regarding the economics of financial fundamentals of the things you're thinking of investing in. You'll simply program a computer to buy and sell according to pre-identified patterns.

There are many advantages to doing this, namely:

  • Your system will be traded around the clock, 24 hours a day depending on what asset you're trading. The system never tires;
  • Your system will be traded consistently. The rules will be followed. Every opportunity that conforms to the rules will be taken;
  • Automating your trading forces you to systematize and plan your strategy, versus the arbitrariness of trading manually;
  • Once the system is programmed, it can be backtested against the historical behavior of the markets. Or it can be papertraded against the present behavior. You'll know how the system did in the past, how it's doing in the present, and everything will be quantified, from the winning percentage of trades, to their profit factor, to the maximum drawdown such system saw in the past;
  • Finally, an automated system will always respect the stop-losses you've defined. It's perhaps one of the hardest things to do as a trader, to respect those.

Personally, I've taken this road. I am increasingly automating my trading as I've lost confidence that the markets will be allowed to trade freely anywhere in the foreseeable future. I expect automated, dumb, systems to outperform myself, and, as a matter of fact, my automated portfolio has indeed outperformed my manual trading over the last year and a half.

Given this reality, I am extending the automated algorithms to more and more areas. I started by trading mostly the EUR/USD (FXE) using these systems, but over time I've expanded them to other forex pairs. Right now, I'm expanding them to deal with equity indexes. And in the future, I expect these systems to also handle individual equities.

I've also found that as markets have turned more and more artificial, there are many patterns emerging. Things that didn't work in the past now do, because prices are being set by a few men, not by a large mass of people. It's thus likely that not only are automated systems profitable, but they promise to become more profitable still, as time goes by and the market goes ever deeper into the centrally-planned rabbit hole.

Is this for daytraders or long term investors?

Removing yourself from the investment loop is a long-term strategy. Index investing is obviously a long-term strategy and only works in the long term. You can easily see drawdowns in the short term as the markets are (mostly) unpredictable.

Automated trading is akin to poker playing. Once you find a strategy which stacks the odds in your favor, you have to religiously stick to it come hell or high water. Again, in the short term even trading a positive expectation strategy can lead to drawdowns and bad beats. But alas, over the long term the strategy, if it has a positive expectation, it should lead to decent gains.

So the answer is, both of these solutions to keep one outside the investment loop are intrinsically linked to investing over the long term.

Conclusion

The markets are turning more and more artificial by the day. Under this scenario, it might be desirable to remove the investor from the investing decision, so as not to let rational decisions regarding economic and financial fundamentals affect the potential returns.

There are two basic ways this can be accomplished. Either the investor decides to use index funds for most of his investing, or he/she can decide to automate the trading and let a machine trade the observable patterns. In my own case I followed this second route, but I believe both can serve today's investor well.

Source: 2 Ways To Take Yourself Out Of The Investment Loop