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Mechanical vs. Emotional Trading

Like most traders I got started as a stock picker following the most basic of rules: do your homework and have a diversified portfolio. This credo is sound, and it’s the approach I use for some of my accounts. The key to this more traditional approach is understanding that your emotions do play a factor in your investing decisions—and that learning how to manage your emotions can be the pivot between success and failure.

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The reason I don’t often discuss trading and emotions is that even after 10 years I have not learned to truly tame my emotions. For this very reason I tend to focus on mechanical trading, which involves consistently implementing a strategy that I craft using measured probabilities, shooting for high occurrences to increase my odds. It’s zero emotion, all math.

Why Do I Say Stock Picking Is Emotional?

Stock pricing (the price at which a trader is willing to buy and sell a stock) is based on similar stocks. For example, when deciding whether to invest in Home Depot I would typically compare the company to Lowe’s and other such retailers, not Microsoft. But we are all affected by brands—even a logo can influence you in ways you might not realize, and so it follows that when comparing one company to another you are likely biased.

Yeah, yeah, I know: you’re comparing numbers such as P/E ratios, not logos, and numbers don’t lie. Or do they? I think they can. You pick which numbers you compare, you decide how to weight each number. Though some of your decisions are informed by experience, some are based on emotions.

Have you ever watched Mad Money with Jim Cramer or read any of his books? Cramer’s father was in retail, and he tells a lot of stories about how he learned retail at a young age. He is clearly knowledgeable about the sector, but also very emotional about it. Though he exhibits the most excitement over retail, his retail stock recommendations tend to underperform his other recommendations.

I can’t quantify the pervasiveness of the phenomenon, but emotions can get the best of a public stock picking sage like Jim Cramer and I know they can get the best of me. It’s something we all need to be aware of when stock picking.

The Mechanical Way

Mechanical trading is a different beast. The approach removes all emotion and relies heavily on math, statistics, and probabilities. Mechanical trading pretty much flies in the face of everything Warren Buffett has ever taught us about making money—it’s an altogether different way of thinking about the market.

Whereas a value investor says, “I believe that sometime in the future XYZ company will be worth more,” a mechanical trader proclaims, “XYZ company has a 63% chance of profit within 3 months.” The mechanical trader typically defines when to enter and exit a trade and the statistical chance of success based on clear mathematical rules, leaving all subjective feelings at the door.

Every trading strategy has its pros and cons, and choosing strategies that play on your strengths is important. I am an optimist. I am also greedy. And I get distracted by flashing lights. That is, I am emotional—which is why mechanical trading works best for me.

Related Topics: emotional trading

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