Why Rules - Based Investing? Take the Emotions out of it.

First, what do we mean by rules-based investing? Rules-based, or quantitative (quant) investing is a data-driven process whereby trades are made based on quantitative factors or rules, effectively taken human emotional biases out of the equation. Why do we want to take emotional biases out? Because they are what prevents active investors from beating the market.

We are better than computers at a LOT of tasks, but unbiased decision making is not one of them. That’s why according to S&P’s SPIVA research, 93% of Canadian Equity funds underperformed the S&P/TSX Composite over the past 10 years, and 85% of large cap funds in the U.S. underperformed the S&P 500. There are many reasons we make bad investment decisions. Smart Asset has written about 10 cognitive biases that hurt your portfolio. Here is a summary:

1.      Confirmation bias: looking for information to confirm something you already believe.

2.      Cognitive dissonance: difficulty deciding against something you believe.

3.      Loss aversion: fear of loss outweighs value of gains.

4.      Risk aversion: preference for safer, more ‘predictable’ outcomes.

5.      Herd mentality: following the crowd.

6.      Anchoring: too much emphasis on the first piece of information.

7.      Endowment effect: becoming attached and overvaluing things you own.

8.      Status quo bias: it’s easier to maintain current state than to make changes.

9.      Recency bias: events that have happened recently get higher priority than past events.

10.   Representative bias: assuming Company A will perform similarly to Company B because they are in the same industry.  

Taking the human emotions out of investing and letting the data do the work can really pay off, especially during periods with a lot of uncertainty. Investors experience a lot of feelings that have little or nothing to do with investing or the markets. Feelings that could be driven by personal circumstances, political views, something you heard in the news, or something as simple as the weather. These feelings can lead to overly negative or positive thoughts towards your investments. You might look at your portfolio, see that it’s down this week and think is terrible and things are only going to get worse. But are they really that bad? Is that what the numbers say? Or is it just part of a normal drawdown in a healthy market?

Of course, the numbers can be wrong sometimes too, there is no such thing as a perfect system, but there are a lot more factors at play, and a lot more noise, that can lead investors to make bad decisions. At some point almost every investor thinks they can beat the market, I know I did in my early days, but the numbers consistently show that even the most highly trained investors make decisions that leave them trailing the markets.