Keep trading and investing simple. Most people instinctively add features and variables in most areas of life. If your trading strategy seems to stop working, you instinctively add one or more variables to the equation. But what if the right course of action is to do the opposite, to remove variables(s)? Less is more in trading!
This article gives you 2 reasons why less is more in trading and why you need to keep trading and investing simple. Adding variables normally increase complexity and you risk curve fitting the strategies to the data. Not only in trading, but just as well in everyday life.
Simplicity is beauty and beauty is simplicity, nothing more, nothing less.”
What is complexity?
Merriam-Webster defines complex as a group of things that are connected in complicated ways – difficult to analyze, understand, or explain.
This certainly applies to all financial markets. The factors influencing the price of financial assets are endless, and even worse, we don’t know the future factors and variables. Complexity compounds – it has exponential growth as you add variables. You just have to prepare for the unknown unknowns.
What is simplicity?
Simplicity is defined as uncomplicated, or uncompounded by Merriam-Webster. For example, treat others as you would like them to treat you. That is an amazingly simple rule to live by (yet many totally ignore it). You don’t need a myriad of legislation when you basically just need one rule (albeit being a naive example).
Why we are inclined to add variables and thus increase complexity: complexity bias
What would you like to do more of? This is a frequent question most people ask themselves. But have you ever tried to ask yourself what you should do less of? If you do less of one thing, you automatically have free time for other endeavors.
The natural inclination in most aspects of life is to add complexity. When facing a problem, we tend to choose the solutions that are the most complex – completely opposite of Occam’s Razor (which states that of two competing theories, the simpler explanation is to be preferred).
Why do we add complexity?
First, complexity sells better. Who wants to buy a trading strategy with two variables when you can have one with eight? Presumably, you get more for your money (keep reading and you’ll understand this fallacy).
Second, when things are simple, it becomes dull and boring. We have made most money in the boring stocks.
Third, the more we know about a subject, the more complexity we prefer. We can argue complexity is a moving goalpost that is changed all the time.
Fourth, hardly anyone wants to hear simple solutions. The more complexity we add, the better it sounds.
Adding increases complexity
Think about the legislation: the length and number of legislation just keep longer by the day, and our lives and societies get more complex every day.
But all legislation has unintended consequences. As you add complexity, you increase the risk of bigger systematic risk. Just think about the EU-wide consequences of the phase-out of all German nuclear power by 2022. It has created ripple effects all over Europe because of the centralized grid.
As of writing, Facebook is down for the 7th hour. This has major consequences for small businesses that rely on their services. Facebook might be (disclosure: we own shares in Facebook) perfect for your business, but a centralized system is vulnerable to systematic risk. It increases complexity as the equation gets bigger and bigger.
This is no different in trading. We add features, variables, and computer power in the belief that this will set us apart from the competition.
But less is more in trading. Instead of adding more, most traders are probably better off by subtracting.
Why it’s tempting to add variables in trading
The amount of noise and opinions in the markets are endless. When we have unlimited amounts of information, it’s tempting to look for patterns and explanations when there are none. We look for solutions and strategies that are more complex than it really needs to be.
We end this article by giving you 2 simple reasons for why less is more in trading:
Why less is more in trading: Reason no. 1
If you’re a systematic trader you are always at the risk of curve fitting your strategies. If you just added one more variable you would have reduced the drawdown from 25% to 10% in 2008…..
However, in trading, there is one rule that should always be in the back of your head:
The more filters and variables you add, the more you risk curve fitting your results.
The instinct is to believe that more complexity and logic add value. All of our monthly Trading Edges are not particularly advanced, but they do work (and have done so for a long time, albeit this is no guarantee it will continue to do so).
Many traders are of the opinion that a strategy should be complex. The more, the better, they believe. Yes, the backtest might be better, but it’s unlikely to hold in an out-of-sample backtest.
If you add many variables, just a tiny change in one of them influences your result. It’s multiplicative. If you have 5 variables, only one change in one of them can turn your strategy worthless.
Why less is more in trading: Reason no. 2
When you add a variable or filter, you remove trades from your backtest. You are throwing away some trades and keeping others.
What does this mean? In practice, you are fitting your variables to the dataset. By all means, this could be smart, but in most cases, it’s not. You really have to know what you’re doing the more variables you add.
When you form a hypothesis and start backtesting, you don’t know if your thinking is correct. Thus, you should always start with the simplest ones and only later add variables by scrutinizing the trades removed from the backtest.
- 26 trading lessons I have learned after 20 years as full-time trader (learning how to trade)
- 6 reasons why backtesting works
- 8 pros and cons of quant trading (Quant trading strategies)
- Survivorship bias in backtesting, trading, and investing (How To Avoid And Minimize It – Examples)
- Disadvantages of backtesting (Why backtesting doesn’t work)
Keep trading simple – Conclusion:
We have earlier written about why programmers and coders are bad traders. Simplicity in trading requires common sense and being street smart – not book smart. One tool comes in handy in that regard: remove variables from the equation.
Why is simplicity important in trading?
Simplicity is deemed crucial in trading to avoid unnecessary complexity and the risk of curve fitting strategies to historical data. The article suggests that adding variables increases complexity, potentially leading to less effective strategies.
Why might traders be tempted to add complexity to their strategies?
Traders may be tempted to add complexity because it tends to sell better, creating a perception that more variables and features offer better value. Additionally, complexity can be seen as more interesting and is often preferred when traders have more knowledge about a subject.
What is the recommended approach when forming a hypothesis and backtesting a trading strategy?
Traders are recommended to start with simple variables and gradually add complexity, scrutinizing the impact on removed trades from the backtest to ensure a more informed and cautious approach.