Friday, December 5, 2014

Kahneman and managed futures



The managed futures strategy is closely aligned with systematic trading, a disciplined approach to making investment decisions. Daniel Kahneman, the Nobel prize winner in economics, provides a good framework for understanding why managed futures managers use systematic trading through his system 1 and system 2 decision framework.

Managed futures are notable for their of systematic trading strategies. In fact more money is run through systematic strategies than discretionary approaches and the performance of systematic managers has been better over the long run. Systematic and discretionary trading performance is usually not highly correlated.

Systematic trading which is often trend-following is an effective balance between system 1 and system 2 decision-making.  From Kahneman, we know that system 1 is associated with fast thinking and decision-making while system 2 is slow and deliberate decision-making. When markets are volatile and often move without key fundamental information, there is a premium with acting fast; however, trading from the gut can be perilous. System 2 decision-making is more deliberate and will take more time. Unfortunately, in fast moving markets, this time for deliberate thinking is not available. Fast market conditions need fast decision-making, but fast markets are often complex and hard to understand. You need to use system 2 thinking, but you are forced into fast decisions which will likely lead to mistakes.  So how is a balance found between these two approaches?

The answer is somewhat easy if you understand how the research process is used to develop models for systematic trading. A CTA, managed futures, can use slow deliberate thinking, system 2, for building models and decision  rules. Testing can be conducted and a careful analysis can be used to find the right decision rules. The models, however, are implemented through the use of system 1 thinking. If certain conditions are met, there is an immediate reaction. There is fast thinking. There is a gut emotional reaction which is acted upon through a model. The fast emotional thinking is tempered through deliberate rules. Fast and slow thinking are mixed to provide the proper set of decisions when market events occur. The decision heuristic or rules-of-thumb that are the hallmark of system 1 thinking are developed through the logical analytics that are represented by system 2 thinking. 

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