Discretionary Versus Mechanical
I have established the concept that you can be an investor or trader. I have established that trading can be fundamentally or technically based. Further, technical trading can be predictive or reactive. And I’ve explained how trend followers are traders who use a reactive technical approach based on price. However, there is even more distinction. Traders can also be discretionary or mechanical.
John W. Henry, one of the best trend followers over the last 25 years, makes a clear distinction between the two strategies: “[I] believe that an investment strategy can only be as successful as the discipline of the manager to adhere to the requirements in the face of market adversity. Unlike discretionary traders, whose decisions may be subject to behavioral biases, [I] practice a disciplined investment process.”15
When Henry speaks of decisions that may be subject to behavioral biases, he is referring to the legions of traders who make their buy and sell decisions based on the sum of their market knowledge, their view of the current market environment, or any number of other factors. In other words, they use their discretion—hence, the use of discretionary to describe their approach to trading.
Decisions made at the “discretion” of the trader are subjective and can be changed or second-guessed. There are no ironclad assurances that these discretionary trading decisions are not colored by personal bias. Of course, a trader’s initial choice to launch a trading system is discretionary. You must make discretionary decisions such as choosing a system, selecting your portfolio, and determining a risk percentage. However, after you’ve decided on the basics, you can choose to systematize these discretionary decisions and from that point forward, make them systematic.
Mechanical trading systems, generally used by trend followers, are based on an objective and automated set of rules. Traders rigidly follow these trading rules (often putting them into computer programs) to get themselves in (buy) and out (sell) of a market. A mechanical trading system can make life easier by eliminating emotion from trading decisions. It forces discipline. If you break your mechanical trading system rules, you will go broke.
Henry puts into perspective the downsides of discretionary trading:
- “Unlike discretionary traders, whose decisions may be subject to behavioral biases, JWH practices a disciplined investment process. By quantifying the circumstances under which key investment decisions are made, the JWH methodology offers investors a consistent approach to markets, unswayed by judgmental bias.”16
It seems a bit rigid to say you can’t even use just a little discretion when faced with a trading decision, doesn’t it? After all, where’s the fun if all you ever do is follow a mechanical model? But then trend following isn’t supposed to be about fun. It’s supposed to be about winning profits. A researcher at Campbell and Company, one of the oldest and most successful trend following firms, is adamant about avoiding discretion:
- “One of our strengths is to follow our models and not use discretion. This rule is written in stone at Campbell.”17
You can see throughout this book that trend followers choose their words carefully and deliberately. It was encouraging to me to find that there are few, if any, instances when their words are not reflected in their philosophies and ultimately their performance data.