A new way of investing in the stock market is gathering steam amongst both institutional and private investors. Rules-based investing is now possible because of advances in technology and the lower cost of investing in ETFs.
Furthermore, this is an approach based on empirical evidence rather than forecasts and opinion. This removes emotion and theory from the process, in favor of statistics and testable strategies.
Investing in the Stock Market: Why now is the time for a Rules-Based Approach
Investing in the stock market is changing
There have been a number of new developments in the investment industry in the last two decades. These developments have led to the emergence of a new and better method of investing in the stock market: Rules-Based Investing. Many rules-based strategies wouldn’t exist or be viable without some of the following developments.
Technology
Firstly, technology reached a point where it was possible for a lot of people to work with massive amounts of data. This allows investors to easily gather, analyze and manipulate data. Off the shelf software is also now available that allows individual investors to build and test their own trading strategies. Most of this technology just didn’t exist 30 years ago. And, the technology that did exist was not available to the average private investor.
Discount Brokers
Secondly, the emergence of discount brokers and online trading has brought the cost of trading down significantly. The amount an investor pays for each trade has a large impact on what strategy will or won’t be feasible to employ.
ETFs
The growth in ETFs has contributed in two ways. Firstly, ETFs have low management fees and no upfront fees, which again lowers the overall cost of investing. The lower cost of holding each asset justifies the extra expense incurred in moving from one ETF to another. The growth in the ETF industry means investors can gain exposure to almost any industry in any region of the world. This gives investors a massive array of options without incurring the risk of investing at the stock level.
The active vs passive debate opens a new door
And finally, the emergence of ETFs has exposed the shortcomings of the Mutual Fund industry. As ETFs were promoted as low-cost vehicles to track a stock index, it became apparent that most mutual funds underperformed their benchmarks. So, while they charged far higher fees, they had little chance of beating their benchmark.
Behavioural finance
Behavioural finance is a field that has been gathering steam over the past three decades. One of the common findings of studies of investor behaviour is that humans are very bad at making decision concerning money. People generally over estimate the value of their own opinions, are influenced by a ranges of biases and have a hard time handling risk.
Investing in the stock market requires a repeatable process.
When you combine these factors, a new approach to investing becomes both feasible and sensible. ETFs are rapidly displacing Mutual Funds because they are cheaper and they do what they promise to do. But that doesn’t mean ETFs are perfect. There has to be a better way to invest than simply tracking market capitalisation weighted indices.
Rules based investment strategies allow investors to make use of low cost vehicles, use strategies based on evidence rather than opinion, and remove the emotion that often clouds investment decisions.
There are a number of approaches to rules based investment. Logical Invest develops strategies to rotate between a basket of ETFs using momentum and volatility. Most of the strategies are optimised to maximise the modified sharpe ratio. In other words, they attempt to maximise the return for a given level of risk.
A growing body of research is pointing to various rules based approaches being the way forward for investors. This is especially true for private investors who are prone to making emotional decisions that can damage their investments.
Summary
The active investing vs passive investing debate has opened a new door. Rules based investing is a better method of investing in the stock market. It benefits from the low cost of ETFs and trading and the ability to use evidence rather than opinion to make investing decisions.