In The Black Swan: The Impact of the Highly Improbable, Nassim Taleb offers a definition of a black swan:
“…an event with the following three attributes. First, it is an outlier, as it lies outside the realm of regular expectations, because nothing in the past can convincingly point to its possibility. Second, it carries an extreme impact… Third, in spite of its outlier status, human nature makes us concoct explanations for its occurrence after the fact, making it explainable and predictable.
Enter Trend Following…
Remember the Gomer Pyle character from The Andy Griffith show? I can see Gomer saying his classic TV line now:
“Surprise, surprise, surprise.”
To comprehend trend following’s true impact you must look at its performance across the biggest events, bubbles and crashes of the last 50 years where it won huge profits in the zero-sum game of surprises.
While world governments and Wall Street are notorious for country wipeouts, central bank errors, corporate collapses, bank implosions, and fund blow-ups that transfer capital from losers to winners, the winners are almost always missing from after-the-fact analysis. Like clockwork, the press is over-the-top fascinated with the losers when surprises roll in. Following their lead, the public also gets caught up in the losers’ drama, oblivious to: Who were the winners and why did they win?
Sometimes they get close to the insight: “Each time there’s a derivatives disaster I get the same question: If Barings was the loser, who was the winner? If Orange County was the loser: Who was the winner? If Procter & Gamble was the loser: Who was the winner?”
Prominent finance academics searching for winners often come up short, as Christopher Culp of the University of Chicago lamented: “It’s a zero-sum game. For every loser there’s a winner, but you can’t always be specific about who the winner is.”
When big market events happen, smart people know the losers’ losses are going somewhere, but time passes and they stop thinking about it or forget the original goal. Reflecting on an implosion is not pleasant: “Fear is still in the bones of some pension fund trustees—after Mr. Leeson brought down Barings Bank. The failure of Barings Bank is probably the most often cited derivatives disaster. While the futures market had been the instrument used by Nick Leeson to play the zero-sum game and someone made a lot of money being short the Nikkei futures Mr. Leeson was buying.”
Someone did make a lot of money trading short to Leeson’s long. But most of Main Street and Wall Street look at it through the wrong lens. Michael Mauboussin sees standard finance theory coming up short when explaining winners during high-impact times: “One of the major challenges in investing is how to capture (or avoid) low-probability, high- impact events. Unfortunately, standard finance theory has little to say about the subject.”
The unexpected events so many bemoan are a source of outsized trend following profits. High impact and unexpected events, the black swans, have made many in this book very wealthy. One trader explains trend following’s success during uncertain times:
For markets to move in tandem, there has to be a common perception or consensus about economic conditions that drives it. When a major “event” occurs in the middle of such a consensus, such as the Russian debt default of August 1998, the terrorist attacks of September 11, 2001, or the corporate accounting scandals of 2002 [and the 2008 equity market crash], it will often accelerate existing trends already in place…“events” do not happen in a vacuum…This is the reason trend following rarely gets caught on the wrong side of an “event.” Additionally, the stop loss trading style will limit expo- sure when it does—When this consensus is further confronted by an “event,” such as a major country default, the “event” will reinforce the crisis mentality already in place and drive those trends toward their final conclusion. Because trend following generally can be characterized as having a “long option” profile, it typically benefits greatly when these occurrences happen.
Said more bluntly: “Even unlikely events must come to pass eventually. Therefore, anyone who accepts a small risk of losing everything will lose everything, sooner or later. The ultimate compound return rate is acutely sensitive to fat tails.” However, big events also generate plenty of inane analysis by focusing on the unanswerable like questions posed by Thomas Ho and Sang Lee, authors of The Oxford Guide to Financial Modeling:
1. What do these events tell us about our society?
2. Are these financial losses the dark sides of all the benefits of financial derivatives?
3. Should we change the way we do things?
4. Should society accept these financial losses as part of the “survival of the fittest” in the world of business?
5. Should legislation be used to avoid these events?
It is not unusual to see market wins and losses positioned as a morality tale to be solved by government. This drama absolves the losers’ guilt for poor strategies (i.e., Amaranth, Bear Stearns, Bernard Madoff, LTCM, Lehman Brothers, Deutsche Bank, Valeant, etc.). Yet the market is no place for politics or social engineering. No law will ever change human nature. As Dwight D. Eisenhower noted: “The search for a scapegoat is the easiest of all hunting expeditions.”
Bottom line, trend following performance histories during the 2016 Brexit event, the 2014–2016 oil implosion, the 2008 market crash, the 2000–2002 Dot-com bubble, the 1998 Long-Term Capital Management (LTCM) crisis, the 1997 Asian contagion, and the 1995 Barings Bank and 1993 Metallgesellschaft collapses answer the all-important question: “Who won and why?”
Fortunately for you, there is a way out. There is inspiration. The great trend followers are not academics, magicians, charlatans, or pedigreed investment bankers. They are self-starter entrepreneurs who, through concentration, drive, and fierce independent streaks, have cultivated that rare knowledge to mint money. Trend following proves daily that the Efficient Markets Hypothesis has more in common with Scientology, versus any useful enlightenment. Understand the comparisons made herein. It’s all part of you figuring out the puzzle and making big money when the next black swan hits.