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Feedback to a James Altucher Article on Trend Following

James Altucher recently posted an article on trend following. The article has brought forward an abundance of feedback. One trend follower wrote me to say:

JWH and the like advertise the riskiness of their investments on their sleeve, while some of the mean reversion hedge fund boys spend sleepless nights hoping no one ever figures out how much risk they are really taking. Who am I kidding? Most of those guys won’t even admit to themselves how much risk they are taking!…there are many different frameworks that one may view the markets through in order to make trading decisions. All such frameworks are what they are, simply illusions that we create in order to help us take some action (yes, even trend following). The test of whether such a framework is useful in the long run is whether it supports us in doing profitable behaviors. If our framework helps us ride winners, cut losses, and manage risk then it is likely to lead us to profits. If the framework is not consistent with these things, then it is likely just part of a bigger game we play to meet some emotional needs and learn some important lessons with some help from the markets…Strategies like the ones Mr. Altucher mentions are not inherently bad. However, by nature they attract investors that have emotional needs that the strategies appeal to (low apparent volatility, feelings of offering value), and the investors are often eager to overlook many of the very real, but hidden, risks involved. It might take a superhuman manager to consistently manage such hard to see risks in the face of constant temptation to go for bigger returns. I don’t like to set up situations where my financial well-being rides on someone consistently exhibiting superhuman skill and willpower. I would rather put my money in something that any idiot can manage as long as they don’t try to get too cute and go around trying to avoid drawdowns.”

My friend added more for those who think they can avoid volatility:

“If one focuses on the volatility of a trend trading strategy while understating its returns, and at the same time one ignores the “one time few-and-far-between huge drawdown events” typical of strategies that are built to avoid short term volatility of returns and one emphasizes the smoothness of the returns that exist outside that one time event, then one has an easily defeatable straw man trend follower to argue against. Reality shows us that strategies that have higher returns have higher risks. If you think you can get high returns without the commensurate level of risk, you might be prone to investing in strategies that do an excellent job of avoiding risk on 99.9% of days, but blow up on the other .1% of trading days.”

But what about “lower risk” strategies such as PIPEs? Feedback:

“What a novel way to avoid being in a drawdown: trade an instrument that is so illiquid that there is no market for it except under special circumstances. That makes it a lot more convenient to pretend that there is very little risk. If I get to make up my own price quote for an instrument on every day between my buy and sell points, then I can create an infinite Sharpe ratio as long as I sell it for more than I buy it. The only case where I ever have to face up to the big risks I really take is if the asset goes to a level that forces me to liquidate at a big loss. In that case my strategy does not appear quite so risk free. I do not mean to lambaste such investing strategies, as I am certain that they have their place. However, such styles are wonderfully efficient means to work out dramas about wanting to feel very safe all the time and not take any big risks and then have things suddenly blow up allowing one to be a victim. Generally, with these types of investments there is pretty high leverage involved if the fund is going to gear the returns to a level higher than a bit above the risk free rate. Under such circumstances the funds models for how much risk premium is warranted in a given situation only have to be a little bit off in a few cases to create a very ugly surprise for investors when the day comes that the fund can no longer maintain the illusion that their made up asset price is real. At that point they are forced to liquidate for heavy losses.”

What about trend followers providing value to the marketplace? Feedback:

“When the people trading the other strategies want to get out of the market when it has moved “too far”, who takes the other side of those trades? Might whoever that is perform the service of adding liquidity? After all, someone might demand to be paid very well for taking positions that are obviously ill advised by folks that have very complex decision making processes to tell them when a market is due to revert to the mean. If one doubts the value of the liquidity provider, consider the prospect of getting out of a trade without anyone to take the other side. This being the case, I fully support and encourage countertrend traders, fundamentalists, and other people that like to fade big moves to keep it up. I need a liquidity provider too.”

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