Mechanical investing, also known as algorithmic trading, has become an increasingly popular approach to investing in recent years. It uses computer algorithms to automate the process of buying and selling assets based on predefined strategies and market data. Proponents argue it eliminates emotional decision-making and allows for more disciplined execution. However, critics warn it carries risks if not properly monitored. This article will examine the potential benefits and drawbacks of mechanical investing.
Mechanical Investing Can Improve Consistency and Remove Emotion
One of the main appeals of mechanical investing strategies is they stick to a set of rules without deviation. Human nature often leads investors to make irrational decisions based on emotion that negatively impact returns. An algorithm simply follows its coded logic without fear or greed coming into play. This regimented approach prevents investors from making impulsive trades that hurt long-term performance. Mechanical systems also benefit from executing far more trades than humanly possible, allowing them to capitalize on even minor inefficiencies.
Algorithms React Faster But Lack Human Judgement
Mechanical investing systems can enter and exit positions in a fraction of a second, far faster than any human. This speed allows them to capitalize on short-term opportunities and get ahead of major market swings. However, algorithms lack human judgement and awareness of broader conditions. They cannot assess the rationale behind price movements or modify strategies on the fly. Sudden changes in market dynamics can cause mechanical systems to generate major losses if not updated quickly enough by programmers.
Complex Algorithms Require Extensive Testing and Monitoring
While simple mechanical investing strategies are relatively easy to implement, more sophisticated algorithms require rigorous development and testing. Programmers must backtest systems across a variety of historical periods and market conditions. Ongoing monitoring is also critical to ensure algorithms are functioning as intended. If input data is compromised or a coding error occurs, mechanical strategies can spin out of control rapidly. Firms must have safeguards in place to deactivate algorithms when anomalies arise.
In summary, mechanical investing provides benefits like emotional detachment, trading discipline, speed, and consistency but also has downsides such as lack of human judgement and need for extensive testing. For suitable investors with the proper precautions, it can be a useful approach as part of an overall portfolio strategy.