Intro to rules based Investing – Why follow an investment strategy?

1. Basics

What is rules based Investing?

In rules-based-investing we define a clear set of rules. These rules comprise an investment strategy. Here is an example strategy:

“At the first day of the month, look at the performance of bonds versus stocks by calulating the 3-month performances of two exchange traded funds, SPY (the SPDR S&P 500 ETF) and TLT (the iShares 20+ Year Treasury Bond ETF).
If SPY outperforms, then re-balance the portfolio to 60% SPY, 40% TLT. If not, rebalance to 40% SPY, 60% TLT.”

Rules based Investment Strategy SPY TLT
Rules based Investment Strategy SPY TLT

 Why follow an Investment Strategy?

 It eliminates our main weakness, emotion.

Developed through years of evolution, our basic human instincts are necessary for our survival. Keeping with the laws of the jungle, these instincts push us to run when in danger and charge when we see opportunity. The stock market, much like a casino, is built to take advantage of these instincts. Investors, if left to their primitive fear/greed instincts, tend to buy high and sell low.

These instincts make a naive person wait for a stock to double, triple, quadruple until every single person he knows claims to have made huge profits. Then he decides to buy, only to see the stock crash!  What happens next to our hypothetical investor, is he looks at a-10% loss and hopes it will rebound. At -20% he starts getting worried, At -27% he thinks of selling but, hey, this may be the bottom, since he want to sell, right? At -40% he goes into shock and stops looking at the stock. At -60%, he gives up and stops checking his account. He feels he has been cheated and exits the markets. It may take years for him to return, if at all.

Following rules, eliminates this process. When the investment strategy dictates for a buy, we buy. When it triggers a sell, we sell. There is still an element of emotion involved but it operates at a secondary level. Is my model correct? Do I trust the model. This, too can be minimized, by backtesting, as we will see later.

It eliminates the Ego (and opinion).

Talking about trading sometimes resembles a teenage boy’s conversation. “I bought this stock when it was $2 and now it is at $200!” “I made $10000 last month”. “I bought an option and made 10x in a week!”. We hear stories like that and assume that they are important. If someone invests $200 and makes $20,000, good for them! But one cannot live off $20,000. That person is not telling you what they may be doing with the rest of their savings, some $500,000 parked at 0% cash. This game is not about how smart you are.

Strong opinions, like the ego may also hinder an investor. This is especially true as we get older and feel wiser. A perfectly logical opinion goes like this: “It is 2011 and interest rates are almost zero. In my opinion interest will rise in the future“( What else can they do?). Thus I will short Treasuries!”
Six years later, that investor may have lost 30% and still stick to his opinion.

Following rules eliminates ego and eliminates opinion. If the investment strategy is programmed to pick up assets that are trending upwards, it will buy treasuries in 2011 whatever you believe. If gold trends downward for years the strategy may drop it, whether you believe in gold or not. Nervelessness there are still biases at play, even when following a strategy. How smart is my strategy? How smart am I for picking this strategy? And so on… But these are easier to deal with. At the end of the day the question should not be, how smart am I but rather how disciplined am I.

Investment strategies help you survive.

History shows that if you invest in an index and stay in the market for 20+ years, you will probably make money. The challenge is to stick around. The more you get involved emotionally in the market, the quicker you will tire and give up. By following a rules-based strategy, you can spend less time watching the markets, reading news and analyses and spend more time doing things you enjoy. In the process you will also improve your health!

Because  in investing, as in life,  your most valued asset is time. The more you have the better your chances are.

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