Motley Fool Mechanical Hibernation

January 14, 2003

October 10, 2003:  Hey!  look at this.  Somebody actually read this page and wrote a very thoughtful reply.  

This site deals with mechanical systems. That is, these systems operate on technical analysis for market timing and for the selection of what to buy and sell. Once the system is built, the operation of the system is entirely mechanical. That is, it requires no thought or judgment.

Now this is not to say that one should reject all thought and judgment after the system is built. One should never abandon common sense. It is always good to stand back and assess the situation from a different perspective. These systems are only supposed to give you a starting point that has worked well in the past.

There is a community of people at the Motley Fool that post on the Mechanical Investing and the Foolish Workshop Message Boards. These people have developed a number of mechanical systems, and continually are developing more.

These systems have, for the most part, the following operational characteristics:

(1) Run a scan. Usually this starts with the Value Line Timeliness picks, and confines it to those stocks rated at the top. The scan may involve earnings, book value, or whatever else is viewed as relevant.

(2) Buy the top N stocks at a fixed time and hold for a fixed period of time. The time period may be monthly, quarterly, yearly, or some other fixed period.

(3) After the fixed period is over, go back to (1)

There are (at least) the following fundamental problems with this approach:

(1) It is really "hibernation investing". That is, you buy something, ignore it for a fixed period of time, and then wake up from your hibernation to re-evaluate the situation. There is no inherent reason why one should invest on the first Monday of the month, or the last Friday, or any other day. The market does not recognize those days as anything significant, so why should you? Similarly, there is absolutely no sense to a fixed holding period. Decisions on stocks should be made based on events. For example, when WCOM and Enron began to tank, there were clear technical indicators that would have got you out well before the end. But if you just blindly hold for a month, year, quarter, or whatever, you miss those indicators, as well as any fundamental changes in the stock(s).

I believe that much of the volatility of the Mechanical Investing screens can be traced to this. Change the start day to a Wednesday and you may get very different results. Basically, they are just basing their actions on matters irrelevant to the trading.

(2) While many of them say that they say that they do not use technical analysis, in fact they do. However, the technical indicator that they use is the weakest and most useless technical indicator of all: IBD's relative strength. This is just a simple ranking over a long period of time. I tells you absolutely nothing about the direction of the stock. It could have doubled then given back half. Such a stock would still have a high ranking because it was up 50%. But the direction of the stock would most likely be negative.

I have a long discussion of ranking methods that actually make sense on the Relative Strength Trading Page.

None of this is particularly original with me. Rudy Stephanel's presentation, linked from that page, is an excellent explanation.

(3) There is an absolute lack of market timing. So when the market is tanking, instead of cutting their losses, they just chant "Follow the Screens, Follow the Screens!", and consider themselves virtuous for doing so. Personally, I do not believe in any kind of virtue that causes me to lose money - at least not if I am trading stocks.

(4) They avoid technical analysis, and say that such systems cannot be backtested. This is nonsense. I have several entirely mechanical systems that trade entirely on technical analysis have been very successful. However, I think that part of their problem is their refusal to use any tools such as Fasttrack, FastBreak, or Trade. There is a whole community of people who use these tools very successfully. So far as I can tell, they have done much better than the MI community over the last several years. Sometimes I think that the MI types are just too cheap to spring for the rather small cost of those tools.

(5) Finally, they spend huge amounts of energy developing new screens when in fact they should question the fundamental premises of the enterprise. Those premises are fundamentally flawed.

They say that one of the advantages of the Mechanical Investing approach is that you do not have to watch the market on a daily basis. This is precisely its most important disadvantage.

The energy they spend on developing new systems, or on tweaking the old ones, would be better used learning how to trade instead of just re-arranging the components of the screens like the deck chairs of the Titanic.

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