Avoiding Common Pitfalls Through Trading Systems

trading system

trading systemOne of the coolest things about trading is that there isn’t really a right or wrong way to do it. There are actually hundreds of different ways to make money trading, and the bottom line profit isn’t even the only measuring stick.

Depending on your capital, risk tolerance, skill, time, and a number of other factors, the strategy that worked for Warren Buffet might not be such a good approach for your situation. Just so I don’t get hassled for picking on Mr. Buffet, the same can be said about John W. Henry. His trading approach also might not fit with your personality.

The Dorsey Wright Money Management blog published a post earlier this month where the author addressed some of the commonalities in investor behavior. The article suggests that establishing a rules based approach can provide a framework that helps many traders avoid some of the common behavioral pitfalls that they are sure to encounter.

Investor Behavior

The article starts by quoting Marshall Jaffe, who discussed how value investors across the board are cursed by behavioral issues. Some of those issues he mentioned included impatience, social conformity, fear, and greed. If you have ever watched Jim Cramer’s Mad Money or searched for a stock symbol on twitter, I’m sure you know exactly what Jaffe is talking about.

The Dorsey Wright article takes Jaffe’s comments a step further and applies them to their approach, which is relative strength investing. I’m sure they would agree that these ideas could actually be applied to just about any form of trading or investing.

The article points out that there are dozens of studies that show the flawed logic that many traders use every day. It also points out that there is a distinct lack of study of average traders or investors who appear you exercise patience and an independent thought process. There is plenty of evidence that markets are driven by fear and greed, but not much evidence that average investors are looking for better ways to deal with those emotions. 

Controlling Negative Impulses

The articles continues by explaining that a systematic approach can be an excellent framework for controlling the type of investor behavior we are looking to avoid:

If you start with an investment methodology likely to outperform over time, like relative strength or value, and construct a rules-based systematic process to follow for entry and exit, you’ve got a decent chance to avoid some of the cognitive errors that will assail everyone else.

Regardless of what type of strategy you are trading, having predefined entry and exit rules is an excellent way to remove much of the emotion from trading decisions. It will also make it harder for your decisions to be influenced by a crazy guy slamming buttons. Booyah!

Of course sticking with your buy and sell rules is easier said than done. That is the final point made in the Dorsey Wright article, and it is also something I struggled with in the past week when a few of my holdings took big losses. The article points out that it is easy to stick to the rules when things are calm, but it gets tougher when fear and greed show up.