Rules-Based Trading: How to Invest Without Emotion Clouding Your Judgment

The easiest way to make money as an investor is to have a simple, effective trading plan. This plan doesn’t need to be complex; in fact, the simpler the better because simple plans tend to stick.

What’s more, a trading plan based around some basic rules removes a lot of the emotion and doubt that can lead any trader astray. A rules-based trading plan keeps you from having to worry “Am I getting in too late?” or “What if this trend doesn’t continue?”. Your plan will handle those contingencies.

The key here is discipline, Nate Tseng writes at Planting Money Seeds. “A disciplined and structured approach to investing can rein in our worst impulses and save us from critical errors. It’s all about rules-based investing if you want to succeed over the long haul.”

Here’s what you need to know about devising a structured, rules-based approach for making buy/sell/hold decisions with your own portfolio.

Rules-Based Trading Keeps You From Making Rash Decisions

Nothing clouds a person’s judgement quite like a vision of making tons of money — or the threat of losing money. Those fears and fantasies will cause anyone to act on emotion, to overestimate their understanding of an opportunity and to lose sight of their investing goals.

In fact, Hans Wagner at Investopedia calls these three sticking points — emotion, lack of knowledge and losing sight of the big picture — the biggest barriers to successful investing. Let’s tackle each one:

Emotions Seriously Cloud Human Judgement

Behavioral researcher Francesca Gino, a professor at Harvard Business School, gives an example of how badly emotion can blind our decision-making.

She cites a study in which participants were asked to guess a person’s weight based on a photo of that person. Participants even had skin in the game here: They were paid based on the accuracy of their estimates.

After they made their guesses, participants were shown one of two films: A documentary about fish or a clip showing someone being bullied. The first film was emotionally neutral, while the second made “people feel angry due to the aggressive and unfair treatment the young man experiences.” From there, participants were given someone else’s guess as to how much the person in the photo weighed, and then were asked whether they wanted to revise their own estimate.

It turns out that people who saw the bullying film and experienced that emotion saw those second estimates in a very different light. Three-quarters rejected the other person’s estimate, whereas the majority of the participants who watched the fish documentary took that second data point into consideration and revised their estimates.

Even with money on the line, people can be swayed by their emotions, even when those emotions are attached to totally unrelated events. Work stress, relationship troubles or a chance glimpse of injustice in the world can affect how we assess our investments.

Too bad for those participants who disregarded the other estimate: The people who revised their estimates tended to be more accurate and thus got paid more for their guesses.

What We Don’t Know Often Gets Us Into Trouble

“Many investors tend to overestimate their ability to beat the market, and as a result they take on unnecessary risks,” Wagner says.

That’s not to say every investor needs to do a night-class MBA to get up to speed. Rather, it’s a matter of recognizing your own blind spots and taking steps to account for those.

It turns out there are even generational trends in the blind spots that traders have. For example, finance writer Brian O’Connell says millennials tend to “take a generic approach to saving,” and often invest their money in companies and funds based on a general feeling that the company or fund in question is reputable.

Boomers tend to have a very different type of problem, argues Aman Raina, an investment coach at Sage Investors. Having come of age as investors in a world full of choice — and a world that was distilled down for them via financial advisors — baby boomers tend to feel intimidated or fearful about making the wrong choices, Raina says. “The current model of using an advisor and having that dependency relationship (‘tell me what to do!’) has failed.”

Later on in this article, we’ll show you how to overcome both of these blind spots.

What Happens When Investors Lose Sight of Their Goals

Wagner argues that many investors get led astray from their long-term goals because they start to chase what they perceive as short-term opportunities. That’s when retirement plans and nest eggs get raided to, in effect, put down a blind bet.

“When the average investor realizes that the market has risen, they pour cash into stocks and mutual funds, trying to capture some of the profit the professionals have realized,” Wagner writes. “When the market puts in a decline, the average investor panics and sells near the bottom. All too often, this pattern continues, causing the average investor to lose much of his or her capital and become disillusioned with stocks.”

You can see how these bad habits and temptations can be self-reinforcing, and as a result they torpedo any investment portfolios. The way to avoid this downward spiral is to have a set of rules that give you clear indications when it’s time to buy, which stocks you should buy, and when you should sell.

Below, we will go into how you can write those rules for yourself.

Rules That Tell You When to Buy

Market timing is the key to understanding when you should buy, sell or hold a stock. As Dr. Bart A. DiLiddo says: “The single most important thing to know is whether the market is going up or down. Everything follows from that.”

Therefore, you want to create a system of rules that anticipate changes in the market and give you clear signals that it’s time to make a decision.

Fortunately, historical data shows us that markets tend to have their own momentum. “The only thing that predicted with great accuracy that this market would go higher over the last eight years or so was momentum,” Shark Asset Management CEO James DePorre says. “Momentum always lasts longer and goes further than seems reasonable. You can’t argue or reason with it. Momentum doesn’t stop until there is some force strong enough to change it — and that force must be quite powerful.”

One thing that isn’t powerful enough to change momentum: Pundits and investors who take to Twitter and shout that this time their prediction of a momentum reversal will come true. DePorre advises investors to ignore that noise and to double down on their own patience. “It is very easy to be mistrustful of an uptrend and to be sucked into the timing game,” he says. “We are easily jiggled out of good positions, and worries about a crash are always lurking. To ride momentum effectively, you have to have some tolerance for pullbacks and dips.”

This is why we built our Color Guard into VectorVest. These buy/hold/sell signals are designed to give you a stoplight that indicates a market’s direction. This removes the guesswork entirely when trying to figure out whether now is the time to buy stocks.

Though he bases his decisions on a different set of indicators, ACIES Asset Management AG chief investment officer Andreas F. Clenow has a clearly defined set of rules that tell him what to do when he recognizes an upward or downward trend in a given market. These rules include opening a long position when the 50-day moving average is above the 100-day moving average so that the position is in line with the dominant trend.

“This is to ensure that we don’t put on trades counter to the dominant trend,” Clenow writes. “It reduces the number of trades and lessens the risk of getting caught in whipsaw markets.”

Rules That Tell You What to Buy

Here’s where a solid rules-based trading system steers you clear of the temptation to buy from a position of overestimated understanding.

Knowing what to buy comes down to two things:

1. Your own understanding of a company, of an industry and of a market
2. Your own tolerance for risk

The first aspect, understanding, was famously captured in Warren Buffett’s idea of a “circle of competence.” Or, as Joshua Kennon at The Balance puts it, you want to put your money in companies you know. Kennon cites the famous investor Peter Lynch, who got his trading ideas from joining his wife and kids as they ran errands. “Lynch bought stock in Hanes after his wife brought home the newly-introduced L’eggs she discovered while in the checkout line at the grocery store; the investment made millions,” Kennon writes.

Risk tolerance is the other half of this equation. Your own appetite for risk depends on what you intend to do with your money and how long you have to let your money grow. “In general, the longer your time horizon, the more risk you can assume because you have more time to recover from a loss,” the Schwab team writes. “As you near your goal, you may want to reduce your risk and focus more on preserving what you have—rather than risking major losses at the worst possible time.”

“I hear that conventional wisdom from customers often, and it’s entirely wrong!” says Dr. Bart A. DiLiddo. “I especially encourage our younger customers to invest in the safest stocks, since they don’t have the earnings yet to replace positions when they make a mistake. True, they have a longer time horizon—to see those positions develop real wealth. Why take on additional risk when they don’t need to?”

Another tool that might be useful for some traders is Humanmetrics’ risk-taking assessment test, which will help identify your appetite for risk.

Several indicators in the VectorVest 7 platform speak directly to investors who are honest about their own levels of comprehension and risk tolerance. For example, the Model Portfolios  and the Long-Term Winners  research portfolios will curate high-performing opportunities, from which you can follow your own line of enquiry to determine whether a particular stock is a fit for your own portfolio.

Further, indicators such as Relative Safety will give you an idea of a stock’s downside. The higher the RS, the safer our information thinks that stock is.

Rules That Tell You When to Sell

Finally, you need to have a system in place that lets you know when it’s time to exit a position and collect (or protect) your profits. This is often the hardest part, and the one most susceptible to emotion-clouded judgements.

Again, patience is important. As Winner’s Edge Trading writes, anyone who has a tendency to “mess around and watch the charts 24 hours, 5 days a week” will drive themselves crazy fretting over when to sell. Instead, they write, having a plan that shouts “Take the profits now!” removes these emotions from the equation.

In general, there are two scenarios that should compel you to sell:

1. When you’ve hit your profit target. This speaks to the need for thoughtful planning in advance. When buying any stocks, you want to have an idea of what you think the upside is (i.e. how much you think you can profit), and then take the profits when you hit that point. Don’t be greedy and keep chasing the profits. You’ll only invite emotions that cause you to make poor decisions.
2. When you’ve hit the stop-loss point. Likewise, have an idea of how low a stock could go when you enter a position, and be prepared to sell at that point to protect your losses. VectorVest has a Stop indicator that can make this calculation easier for you.

There is one more scenario that will tell you it’s time to sell, and that’s when you see clear signs that you’re about to enter a bear market. We will explore how to recognize bear market scenarios in an upcoming post.

For now, it’s important to understand the tools available for supporting your profit target and stop-loss scenarios. Scottrade does a good job of breaking these down. Here are the three worth focusing on now:

• Limit orders. These are orders you can place in advance to sell a stock once it hits a target price.
• Stop orders. Stop orders do the same thing, more or less, but they’re triggered when a share price dips below a certain point. This is how you protect your losses.
• Bracket orders. Bracket orders are a combination of the above. They limit the upside and downside your stock is exposed to so that “you are effectively able to establish two selling prices on the same security.”

Note, however, that these orders don’t create rock-solid price guarantees. “It’s quite possible, and in some cases even likely, that the stock will not actually trade at the exact stop-loss price but rather ‘gap’ below that price level,” says Andrew Crowell, vice chairman of D.A. Davidson & Co.’s Wealth Management division.

“If this happens, once the stock trades through the stop-loss price, the stop-loss trade becomes a market order and will then be in the queue to be executed. The actual trade may happen a few pennies or even many dollars below the entered stop-loss price.”

A rules-based trading system is never going to be 100-percent watertight, and there is always room for adjustments, tweaks and revisions. The rules you create will be useful for informing how you go about making those adjustments. In the meantime, limit and stop orders do essentially put bumpers around your positions.

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If you are interested in seeing some rules-based trading portfolios in action, have a look at our 2018 model portfolios in VectorVest 7. Each was built using very clear rules, and each has outperformed the market average.

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