Are Computers Human 5

There is one mistake that costs investors billions of dollars every year and yet investors continue to repeat it. This mistake happens primarily because investors are emotional and overconfident. Being emotional is the main reason for so called “timing” mistakes.

The market research firm Dalbar Inc. calculated, for the period between 1994-2013, that due to such poor timing decisions the average US equity investor achieved an annualized return of 5.0% while an investment in an index fund generated 9.2%! A similar result is shown for investors into bonds.

Are Computers Better Humans 2

So, it’s not that the primary underlying product has underperformed, but that the investors were just not in the market when they should have been.

Why Is This The Case?

Investors are emotionally influenced by market volatility when entering and exiting markets. Equities have provided investors with the highest risk premium, but they also have been subject to high volatility and extreme drawdown. The No. 1 investing mistake that everyone makes, along with trading too much, is that we often do it at the worst times.

This happens in particular when investors do NOT follow a well defined proven investment strategy, but just buy and sell when they feel it is ok. Therefore, an important condition to becoming successful at investing is to employ a strategy that works (which ever you select). Then you should be consistent and adhere to it. Remember the Marshmallow Test article of last week using a model?

Why Use a Model?

In 2000, William M. Groove, today an Associate Professor at University of Minnesota, Department of Psychology, did a meta-analysis, or study of studies, on 136 published papers across a wide range of professions (not specifically investing). They analyzed the accuracy of quantitative models versus expert judgment. Models beat experts 94% of the time! Human judgment prevailed over quantitative models in only eight studies, and all of these had access to information that was not available to the quantitative models. Even when given access to the quantitative model results, experts still underperformed the models.

Grove summarized “humans are susceptible to many errors in clinical judgment. These include ignoring base rates, assigning non-optimal weights to cues, failure to take into account regression toward the mean, and failure to properly assess co-variation.”

The commercial airline industry realized a long time ago that models work and introduced autopilots after which human pilots literally became system managers. The most extreme version is the “Cat III C” precision instrument approach. This system allows for landing with no “decision height” (the specified altitude at which the pilot must decide to continue or abort the landing). It is used when there is literally nothing a pilot can see due to the airport being covered with heavy fog, rain, or blowing snow. An airport equipped with a Category III C system allows an aircraft’s autopilot to land the aircraft automatically and can also provide guidance along the runway surface. The airline industry uses it every day because it works.

There is no reason for a pilot to question if the airplane is really on the glide path to potentially interfere because the system has been proven much better and more reliable than the pilots in the cockpit. If we take 100 similar planes with the same autopilot system (in similar weather conditions) we get 100 times the same result. If we let 100 pilots landing the airlines land manually guided by the instruments in the cockpit we get 100 different results and may be some wouldn’t even make it properly until touchdown due to human error.

Once investors realize the benefits of using a proven system, they can become better investors with more reliable and superior results. One of the best systems traders on the planet, American mathematician and multi-billionaire Jim Simons, founder of Renaissance Technologies and the Medallion Fund gave a talk at MIT entitled, “Mathematics, Common Sense, and Good Luck: My Life and Careers” where he said: “If you’re going to trade [invest] using models you just slavishly use the models. You do whatever the hell it says no matter how smart or dumb you think it is at that moment.”