Why We Trade Systems

We trade systems for two primary reasons:

• First, because trading involves emotions, we’d be our own worst enemy if we didn’t follow a rules-based approach

• Second, we (and most others) are really terrible when it comes to making predictions

Emotions and Biases

Expanding on the first bullet point, through our own experience and having read the excellent works of Kahneman and Tversky on Prospect Theory, we understand that when making investment decisions people tend to see what they want to see. It’s tempting and convenient to look at the world through rose-colored glasses and ignore the facts.

Even worse than being inappropriately dreamy about the future, we are inclined to stick to our opinions (and trading positions) even when we are wrong. The “cognitive dissonance” usually arises when we are confronted with new evidence that challenges our established framework. Like magic, an unconscious mechanism kicks in which causes us to defend and uphold our incorrect view of the world. In other words: We’re really good at making stuff up.

There are two kinds of forecasters: those who don’t know, and those who don’t know they don’t know — John Kenneth Galbraith

If we hold a position in the market, or a set of beliefs about how the world works, and we learn that our beliefs are incorrect and/or our position shows a loss, logic dictates that we must either admit that we are wrong and change our position or reject the evidence we are presented with. But, because changing our mind can be painful and feel like admitting defeat, we have a propensity to reject the new data and start researching new “facts” which support our original thesis. We’d rather go on a rescue mission for our established conceptions than start over. In trading, however, these rescue missions can lead to ruins and blow-ups.

Following a rules-based, systematic trading process allows us to keep emotions and biases in check. Rather than clinging to any views, opinions, or market forecasts, we prefer taking appropriately sized trades with an asymmetric risk-reward ratio over and over again. When we lose too much, we’ll cut the position and move on. Losing is part of the process, and as silly as this may sound, every good trader is a professional loser. Being professional about losses is what keeps us in the game for the long run and increases our odds of success.

Unknowable Future

Let’s now consider the second bullet point. In order to produce something useful, one must have a reliable method, i.e., a repeatable process that’s capable of converting certain inputs to a desired output. Our issue with predictions, e.g., macro forecasts, is that there are simply too many interconnected and volatile variables which make coming up with a useful signal impossible. In light of all these complexities, macro forecasters are forced to make several assumptions such as analyzing economic factors in the aggregate, or only for a select group or market. There’s no way to predict the future that doesn’t require the making of assumptions.

The distribution of forecasting accuracy by the gurus looked very much like the bell curve—what you would expect from random outcomes — Larry Swedroe

Inconveniently, while small errors in these assumptions can lead to different outcomes, random exogeneous events can derail everything at once. A prime example of randomness is the Covid-19 pandemic which caused much of the economic world to shut down and triggered massive fiscal spending. It was impossible to anticipate the pandemic, let alone its financial impact.

Good luck putting all of this together and disentangling the Spaghetti. Nassim Taleb calls people who do it “macro bullshitters” in this Odd Lots podcast.

Forecasts create the mirage that the future is knowable — Peter Bernstein

Somewhat unsurprisingly, while macro forecasters are eager to bombard us with their predictions for a fee, rarely, if ever, do they mark-to-market. People who mark-to-market have skin in the game, take risks, and own the P&L of their decisions – a macro hedge fund, for instance. Like us, these funds are in the business of making money as opposed to sharing predictions widely with the outside world. Clearly, any sustainable edge in the markets is too valuable to be given away for free on X, formerly Twitter, or through a newsletter.

Moreover, when people don’t mark-to-market, they can get away with being wrong. Can you imagine hiring an investment manager without reference to a track record? Probably not. But macro forecasters without real track records are hired all the time. That’s because they have a great “trick” up their sleeves, essentially a free option: If the prediction didn’t come true, the forecaster can roll the dice again without suffering any direct financial consequences, and sway clients by

• selectively recalling correct forecasts from the past, especially bold ones

• over-emphasizing predictions which turned out correct, and discounting or minimizing those which didn’t materialize

• focusing on the huge opportunities that lie ahead, usually without stating an exact time horizon over which these opportunities are expected to pay out, or using an ultra-long-time horizon (during which anything can happen)

• selectively benchmarking against others (we still did better than “them”)

• saying that unsuccessful forecasts were unfairly impacted by random events which nobody could have seen coming

Conclusion

We accept that we don’t and cannot know the future. Markets are second-order chaotic systems with feedback loops that actively respond to predictions. The dynamics of these systems are impossible to forecast. Therefore, making predictions about market prices is pointless.

The good news is that we don’t have to know the future to be successful as traders. In fact, it is our mission to grow our investors’ capital in the absence of any knowledge about the future.

It is an iron rule of history that what looks inevitable in hindsight was far from obvious at the time — Yuval Noah Harari

Although our systems use historical price data as inputs, it does not mean that what has happened in the past is predictive of what might happen in the future. The future will never be an exact replay of the past. There may be similarities, but there is never an exact parallel.

It's frightening to think that you might now know something, but more frightening to think that, by and large, the world is run by people who have faith that they know exactly what’s going on — Amos Tversky

Fortunately, a feature that doesn’t depend on past price data is our “superpower” of keeping losses small while letting winners run on. Rather than attempting to foretell an unknowable future, trend following strategies determine the path of least resistance and take small probing bets in the direction of price movement. This is what protects our core capital; this is how we cope with the many curveballs the markets throw at us; and this is how we cope with emotions and biases, allowing us to survive as traders in the face of uncertainty.

A big THANK YOU to our friends Klaus Wobbe and David Pieper at Intalcon where this article appeared first.

PS - A couple of days after we wrote this blog, Larry Swedroe published this timely and excellent article on Wealthmanagement.com. Its title is “The (in)accuracy of market forecasts” and here are a few great quotes from this article:

The takeaway is that market forecasts should be ignored, regardless of whom they come from—professional economists or market gurus. Instead, investors are best served by having a well-thought-out plan

Forming macro opinions or listening to the macro or market predictions of others is a waste of time. Indeed, it is dangerous, because it may blur your vision of the facts that are truly important — Warren Buffett

For investors who haven’t learned that such prognostications should only be considered entertainment, or what Jane Bryant Quinn called “investment porn,” they, in fact, have negative value because they can tempt investors to stray from well-developed plans