When trading with algorithms, investors essentially trust computers to do the hard work for them. After all, computers don’t sleep. They don’t take holidays. They don’t get caught up in emotional decision-making. These are just some of the reasons why algorithms are proving to trump humans in the world of investing.
Let’s define algorithms
Before we get into the ‘why’ of algorithms in investing, let’s look at the ‘what’. What exactly are algorithms anyway?
In a nutshell, an algorithm, or algo, is a process or set of rules a computer follows when making calculations or solving problems. When it comes to investing, algorithms set out instructions based on a variety of factors, including:
- Asset type
With these instructions in place, a computer or piece of software can execute trades faster than any human possibly could. Algorithms make decisions purely on data rather than on ‘gut feel’, with the aim of achieving the most profitable outcome for the investor.
Algorithmic investing and by extension, robo-advisors, have grown steadily in recent years as more people – and companies – recognise the benefits of automating their trading decisions. By some estimates, 90% of trades today are carried out by investment algorithms.
What do Rubik’s Cube algorithms have to do with investing?
Most of us are familiar with the Rubik’s Cube – but few of us know how to solve one quickly. A Rubik’s Cube has six sides with a different colour on each, and every side has nine pieces. This means there are 43 quintillion (that’s 43 followed by 18 zeros) possible combinations you could try before hitting the jackpot and solving the Cube.
But pros know that, with a few simple steps (AKA an algorithm), you can work layer by layer to unlock the solution every time. And you don’t need to try 43 quintillion combinations to get there. This is how some people know how to solve a Rubik’s Cube in under a minute.
So, what does all this have to do with investing? In a huge pool of investment opportunities, it’s virtually impossible to consistently beat the market. There are so many possible combinations to consider that you can’t get it right every time. Investment algorithms, much like Rubik’s Cube algorithms, follow a process to produce the best result as fast as possible, every time.
Investment algorithms > humans
Does an algorithm outperform the average investor? Researchers recently put this question to the test by building an investment algorithm and comparing it to various human investors in a simulation.
What they found is the algorithm significantly outperformed the average novice investor, and even experienced investors who fell prey to cognitive biases.
When you think about how investment algos work, it’s easy to see why they often outperform humans:
- They interpret millions of data points in a second: an impossible feat for even the smartest of humans
- They’re not emotional: they can ‘read’ emotions but they don’t make potentially bad decisions based on things like gut feel, greed or psychic predictions
- They never sleep or rest: trades can happen any time there’s an opportunity
- They aren’t biased: algorithms are designed to make 100% logical and high probability trades
And let’s face it: most of us don’t want to spend all our waking hours figuring out where to invest next. Algorithms not only make better decisions faster, but they also allow us to enjoy life while the returns roll in.
If you want to take the guesswork out of investing, consider using a robo-advisor such as Unhedged. Robo-advisors use AI-driven trading algorithms to maximise the returns for you.
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