Sunday, July 5, 2015

Never Override Your System

In the previous post, I gave an analogy showing that investors shouldn’t follow a passive (buy-and-hold) strategy. That instead, they should have an active strategy that changes their portfolio to prevent severe bear market drawdowns. This strategy must be systematic, simple and thoroughly researched. In this post, I want to give another analogy to show the importance of not trying to outsmart your system.

Let’s begin.

This weekend, I went to Manning Provincial Park in BC. This is about a 2.5 hour drive from Vancouver and travels mostly along our Trans-Canada Highway #1. As we were driving back home, we were hit by a big traffic jam.

We had three options:
  1. Stay on Highway #1 no matter what because it’s the highway 
  2. Use Google Maps to try and bypass the traffic
  3. Use our own intuition to try and bypass the traffic

Option 1 is analogous to a passive (buy-and-hold) investment strategy. Options 2 and 3 are analogous to active strategies, with 2 being systematic and 3 being discretionary. Just like Google Maps successfully uses traffic data from local drivers to help you dodge traffic jams, a proven systematic investment strategy can help you dodge bear markets.

Immediately, I pulled out my phone and checked Maps for the best way to bypass the traffic. However, the route that Maps was displaying looked strange to me so I used my gut feel to override it. I told my friend who was driving to exit off the highway and get onto this small road that traveled in parallel with the highway.

Initially, we were thrilled to be zipping past all the highway cars. But it wasn’t long before our road ended at a canal. After wasting time searching for a way to get back on the highway, we were significantly behind both method 1 (staying on the highway) and 2 (Google Maps).

From my investing experience, I can tell you that when I first started using a systematic approach, my lizard brain often got in the way and tempted me to override my system. I thought that somehow, my intuition was much more intelligent than an unconscious mechanical model. Whether it was a new fancy indicator that I found or a news headline screaming financial crises after just a small pullback, I would be tempted to go against my plan.

And sure enough, anytime I bypassed my system it was often followed by disastrous results. Just like when I bypassed Google Maps this weekend. There is simply no place in investing for intuition, gut feel and predictions. You must be an unwavering slave to your system.

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