The question of whether humans or computers are better at trading has been around since the era of the punch card. The question rings in the halls of some of top money management firms and Ivy League schools today.
Many academics and financial professionals profess that the best traders are born with an inherent sixth sense of the markets that becomes more refined through experience. Images of Peter Lynch and John Paulson come to mind. In contrast, those that are pro-algorithm believe that human emotion, bad hunches, and an impossible ability to crunch vast amounts of data make the mirror-fogging competition prone to less profitable trading. Famed traders like David Harding and Ed Seykota are shining examples of algorithmic technicians with incredibly good market-thrashing long-term returns.
Both camps make a compelling, so instead I submit to you the top reasons why you should (or shouldn’t) trust a human or a compute with your hard-earned dough.
The Forbes 100 list is littered with famous traders, some of whom have made a fortune because of correct hunches and big bets. These legendary investors see the markets in a different dimension than ordinary humans. They bravely bought stocks that no one else was buying and caught a huge profit. They bet against the housing market before the crash of 2008 and against technology stocks before the crash of 2000. They possess an uncanny ability to “sniff out” opportunities that seem invisible to others.
Humans make better traders because:
- They learn from experience and can infer from seemingly unrelated information.
- Humans can talk with other humans about fundamentals of a company or economic data about a country and form a unanimous decision about what investment action to take. Having this committee approach to investing can help weed out bad bets.
- While human traders are far from perfect, they very rarely make huge incorrect trading errors like those of Knight Capital where a faulty algorithm nearly caused the company to collapse.
Computer algorithms have infiltrated our daily lives making our lifestyle easier, safer, and maybe even more romantic. If it weren't for computer algorithms your car wouldn't brake so quickly or use fuel so efficiently. You wouldn't be able to scan trillions of documents from around the Web with a search engine, or find your soul mate by using a dating site.
If we rely on algorithms every day to live better, why not rely on them to make better trading decisions? Computers make better traders because:
1) Algorithms never have a bad day, they never call in sick, they aren't biased, never have clouded judgment because of a fight with their spouse, they never die, and they can work 24/7.
2) Computers can digest huge amounts of data, pull in every scrap of valuable information, and make a “smart” investment decision based on the parameters given.
3) Computer algorithms are consistent performers. You can’t replicate a human’s discretionary trading (because it doesn't follow a set of logic), but you can expertly craft and back test a defined algorithmic investment strategy. Trading algorithms ultimately provide humans a level of peace and confidence that comes from knowing that your system works over long periods of time regardless of geo-political events or volatility.
Maybe the Best of Both?
Maybe humans aren't the best traders. They make irrational mistakes and their trading wisdom dies with them. And maybe computers don’t make the best traders either. They may be prone to costly trading errors because of buggy programming (by humans) and can’t fully learn from their mistakes.
So, why not take the best of both traders? My background is in technology and innovative systems development, so naturally I tilt toward the algorithms, but I cannot ignore the benefit of human cognitive ability to solve problems and learn from experience. The best trader is the combination of well-designed and tested algorithms with the critical, discerning eye of a human.
Do want to make more money in the markets, have more confidence in your investment approach, and trump some of the best fund managers? I believe it all starts with defining and then refining your investment strategy into parameters that can be tested and proven over long periods of time. Once you have built a foundation you really have confidence in, make sure you monitor all trading activity and do not rely on your computer for automatic trading. You’re master of your own universe.
Robert Russell is the author of Retirement Held Hostage, CEO & CIO of the Ohio-based Russell & Company, a private wealth management firm specializing in helping affluent individuals ages 45 and up create and preserve their wealth. He co-hosts a radio show, authors The Rob Report blog, and is a frequent contributor to The Wall Street Journal, SmartMoney, & FOX Business.