Mechanical investing: pros & cons

Mechanical investing has two great advantages:

  1. it is dispassionate and free from personal bias and herd mentality, and,
  2. mechanical strategies can be verified by back-testing

The ability to test mechanical strategies rigourously is fairly clear. Back-testing is possible so it is possible to quantify both how well a strategy performs over the long term, and how consistently it performs. It is very difficult to rigourously test a strategy that involves human judgement as people cannot forget what they know about market movements more recent than the period they are looking at. Identifying individual stock picking talent is almost as difficult because some will inevitably out-perform through sheer luck (they are just in the tail of the probability distribution).

The advantages of dispassionate and impartial evaluation can hardly be over-valued. Investors have repeatedly proven to be vulnerable to fear and greed, and the desire to join the herd — simply because it is human nature, and because professional investors often have incentives to follow the herd (fund mangers are not fired for producing market performance). This is why bubbles inflate and then burst.

Mechanical strategies also take little time (because automated stock picking replaces fundamental analysis) and are often cheap (because a portfolio is bought, and then occasionally re-balanced, so trading costs are infrequently incurred). The latter is not inevitably true: a disciplined investor buying for the long term may trade even less frequently and there many mechanical strategies specifically for day trading.

The main disadvantage of a mechanical strategy is the simple lack of intelligence in the process. A person performing fundamental analysis may well be able to say "that share is cheap because the company sells to a shrinking market", whereas as all a mechanical strategy will see is a low PE, and a high yield.

Mechanical strategies also lack flexibility. In order for a mechanical strategy to successfully save in investor from their own emotions, it needs to be adhered to long term. This means not being able to exploit the opportunities offered by another strategy, and it means not being able to exploit market conditions. For example, and investor c omitted to a a yield based mechanical strategy (one of the most popular) will never be able to buy a low PE share that has a temporarily low yield, or any growth opportunity, or to ride the momentum of a current market trend. Mechanical strategies save us from the follies exposed by behavioural finance, but also prevent us from exploiting them.