Mechanical Investing – Stock Selection on Autopilot

As most investors know, there are two types of investors. There are the active investors who actively research stocks through fundamental analysis, technical analysis, top-down or bottom-up analysis, or any combination of these. These investors are actively looking for mis-priced stocks. There are also the passive investors – those investors who invest using index funds, making their investments in overall markets as opposed to individual stocks. Individual stock selection is not done here. Somewhere in bewteen these two types are the mechanical investors, or those who buy and sell securities based on pre-determined criteria. Its primary purpose is to remove all emotional decisions out of the investing process.

There are a lot of different mechanical investing strategies out there. I would suggest that the most popular of these strategies is one I have written about before – Dogs of the Dow. There are also a couple that have been created by the guru of mechanical investing, James O’Shaughnessy. O’Shaughnessy has written a couple of books on the subject, most notable of which are What Works on Wall Street and How to Retire Rich. Again, the impetus behinds all of these strategies is removing the negative impacts of emotional decisions on investing performance.

My experience with mechanical investing is that it is much harder to actually implement than one expects. For example, in the O’Shaughnessy screens, an investor is required to purchase 50 stocks to properly implements the strategy (this is to reduce individual security risks). The costs associated with this is huge ($9 round trip in and out of a stock X 50 = $450 in commissions) as well as the initial starting capital that is required so that commissions do not eat all your gains (i.e. to keep commissions at around 1% you will need a minimum of $25,000). In addition, O’Shaughnessy suggests that an investor use a couple strategies to help balance risk.

Although I know how important it is to keep emotions out of investing, when push comes to shove it can be much more difficult. I have found that I am much better at doing this when I have selected my own securities rather than having a screen do it for me. I think the reason is that with a screen, there is a feeling of no control which make me feel uneasy. I have no input into the stocks selected and need to “hope” that the screen works. When I choose a stock, I have put my own analysis into it and feel more comfortable about my decision – more control. I know my own analysis is no guarantee, but the screen provides no guarantee either. I want to have more control.

My belief is that if one wants to take all emotion and decision making out of investing, then a passive index based investing strategy is the way to go. The index does the investing for you, and your only involvement will be making sure you don’t panic when the markets tank!