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Herd Behavior: Excerpt from Trend Following, 5th Edition

An excerpt from my most recent edition of Trend Following:

Trend following is as much about observing and understanding human behavior as it is about moving averages, breakouts, and position sizing. Understanding human behavior and how it relates with markets is commonly referred to as behavioral economics or behavioral finance. It evolved from the contradiction between classical economic theory (EMT) and reality. The assumption people act rationally, have identical values and access to information, and use rational decision making is one preposterous assumption.

However, trend following strategies only work if price trends continue. But why should trends continue? If prices initially under-react to either good or bad news, trends tend to continue as prices slowly move to fully reflect changes in fundamental value. These trends have the potential to continue even further as investors herd (or chase trends). Herding can cause prices to overreact and move beyond fundamental value after the initial under-reaction. Naturally, all trends must eventually end, as deviation from fair value cannot continue infinitely. Said another way, people are irrational as hell and seldom make rational decisions even if they think they do. That’s not my one-man opinion either. I have had the good fortune to learn from and interview the top minds in the field of behavioral economics and finance, including Nobel Prize winners Daniel Kahneman and Vernon Smith, Dan Ariely, Colin Camerer, Christopher Chabris, Robert Cialdini, K. Anders Ericsson, Gerd Gigerenzer, Donald MacKenzie, Spyros Makridakis, Terrance Odean, Steven Pinker, Laurie Santos, Hersh Shefrin, Daniel Simons, Paul Slovic, Didier Sornette, Meir Statman, Brett Steenbarger, and Philip Tetlock to name a few of the best minds in the field. (You can find these interviews on my podcast at www.trendfollowing.com/behavior.)

Some want to argue about everything but this. Big mistake.

Willful Ignorance: Trend Following Radio Feedback

Feedback in:

“Most of the misinformation is not deliberate. People want to be led astray. They constantly ask the wrong questions, and those selling information get rewarded by giving them the answers they want.” -Van K. Tharp, Trade Your Way to Financial Freedom

I think CNBC will be around in 50 years, probably answering the same types of questions.

Love the podcast.
[Name]

Thanks!

Note: His feedback is on this.

Willful Ignorance
Willful Ignorance

Humans Naturally Follow Crowd Behavior

Great article in the Wall Street Journal by Alison Gopnik titled, “Humans Naturally Follow Crowd Behavior”:

It happened last Sunday at football stadiums around the country. Suddenly, 50,000 individuals became a single unit, almost a single mind, focused intently on what was happening on the field—that particular touchdown grab or dive into the end zone. Somehow, virtually simultaneously, each of those 50,000 people tuned into what the other 49,999 were looking at.

Becoming part of a crowd can be exhilarating or terrifying: The same mechanisms that make people fans can just as easily make them fanatics. And throughout human history we have constructed institutions that provide that dangerous, enthralling thrill. The Coliseum that hosts my local Oakland Raiders is, after all, just a modern knockoff of the massive theater that housed Roman crowds cheering their favorite gladiators 2,000 years ago.

(For Oakland fans, like my family, it’s particularly clear that participating in the Raider Nation is responsible for much of the games’ appeal—it certainly isn’t the generally pathetic football.)

In fact, recent studies suggest that our sensitivity to crowds is built into our perceptual system and operates in a remarkably swift and automatic way. In a 2012 paper in the Proceedings of the National Academy of Sciences, A.C. Gallup, then at Princeton University, and colleagues looked at the crowds that gather in shopping centers and train stations.

In one study, a few ringers simply joined the crowd and stared up at a spot in the sky for 60 seconds. Then the researchers recorded and analyzed the movements of the people around them. The scientists found that within seconds hundreds of people coordinated their attention in a highly systematic way. People consistently stopped to look toward exactly the same spot as the ringers.

The number of ringers ranged from one to 15. People turn out to be very sensitive to how many other people are looking at something, as well as to where they look. Individuals were much more likely to follow the gaze of several people than just a few, so there was a cascade of looking as more people joined in.

In a new study in Psychological Science, Timothy Sweeny at the University of Denver and David Whitney at the University of California, Berkeley, looked at the mechanisms that let us follow a crowd in this way. They showed people a set of four faces, each looking in a slightly different direction. Then the researchers asked people to indicate where the whole group was looking (the observers had to swivel the eyes on a face on a computer screen to match the direction of the group).

Because we combine head and eye direction in calculating a gaze, the participants couldn’t tell where each face was looking by tracking either the eyes or the head alone; they had to combine the two. The subjects saw the faces for less than a quarter of a second. That’s much too short a time to look at each face individually, one by one.

It sounds impossibly hard. If you try the experiment, you can barely be sure of what you saw at all. But in fact, people were amazingly accurate. Somehow, in that split-second, they put all the faces together and worked out the average direction where the whole group was looking.

In other studies, Dr. Whitney has shown that people can swiftly calculate how happy or sad a crowd is in much the same way.

Other social animals have dedicated brain mechanisms for coordinating their action—that’s what’s behind the graceful rhythms of a flock of birds or a school of fish. It may be hard to think of the eccentric, gothic pirates of Oakland’s Raider Nation in the same way. A fan I know says that going to a game is like being plunged into an unusually friendly and cooperative postapocalyptic dystopia—a marijuana-mellowed Mad Max.

But our brains seem built to forge a flock out of even such unlikely materials.

For more see:

Nice perspective.

Ep. 241: A Cult-Like Indoctrination with Michael Covel on Trend Following Radio

A Cult-Like Indoctrination with Michael Covel on Trend Following Radio
A Cult-Like Indoctrination with Michael Covel on Trend Following Radio

Have you noticed with equity markets at all time highs there are starting to be justifications again? It reminds Michael Covel of… The “this time is different” routine. Covel moves on to talk about Timothy Geithner’s new book, and how Warren Buffett approached him after bailouts. Covel talks about crony capitalism on both sides of the aisle. Rigged markets at all-time highs are not fun. It may feel great at the time, but there’s a hangover. Covel shifts gears and talks about classical economics. It’s all about assumptions that become axioms. Covel discusses the Black-Scholes option pricing formula, and how the edges are indeed important. Covel can’t predict or tell you when or how, but he can tell you that if you’re in a position with a system to take advantage of price movements, you can benefit on the upside, the downside, and the black swan side. Next, Covel gives an example of someone who was mugged outside of a bar and became a mathematical savant after brain injury. Given these gifts, will he work for Wall Street? There are too many variables to make a prediction, he says. Next, Covel moves onto a TED talk. He’s thought they’ve always been enjoyable–until now. It turns out the TED operation operates like a cult, as evidenced by a clip from the Joe Rogan podcast. Covel wraps it all back to classical economics–it’s a cult, too.

Keep Calm, The Fire Rises

Listen to this episode:

Ep. 101: A Love Affair with Apple with Michael Covel on Trend Following Radio

A Love Affair with Apple with Michael Covel on Trend Following Radio
A Love Affair with Apple with Michael Covel on Trend Following Radio

For the past couple of years many of us have been in love with Apple. Their products, their style, and their stock. It was a great story as long as the stock was going straight up. On today’s podcast Michael Covel talks about all things Apple: the worship; the seemingly romantic love of Apple stock; and the drop down to $450 a share from its peak above $702.10 in September (down 35% from its peak). Covel compares the fundamental viewpoint looking at Apple today to the trend following perspective that is purely based on price action. The Wall Street analysts all seem to insist that they can predict the future, but none of them predicted this. So, what does this mean? Is Apple a “broken company”? Apple had a profit of 13 billion dollars, sold 28% more iPhones and 48% more iPads, and the stock still went down. Covel looks at several articles from Wall Street analysts and notes that none of these people were saying what they’re saying now when the stock was at 700 a share. Covel creatively points out the complete drivel coming from these analysts, and notes how nothing has changed on Apple’s end but the price of their stock. So why is this only being pointed out now? And what is Covel’s ultimate point? Follow the price action. Trend followers don’t have to know anything about what’s going on inside the back room of an Apple store. This is a classic example of a trend: ride the train up, ride the train down. Is the stock cheap now? What if it’s at 350 or 250 next month? Do you buy on the dip? If the market is going down, get out or short it. The price knows more than any Wall Street analyst. There is no way on the planet to attach all fundamental views to the movement of the stock price. If the best traders on the planet don’t have these insights, how can the stock jockeys at CNBC and Bloomberg, for example, have them?

Listen to this episode:

Too Simple: A Big Reason Many Investors Miss Trend Following

An unexpected source explains why many miss understanding trend following trading:

If the explanations you’re demanding for what works aren’t working, perhaps it’s because you’re avoiding nuance in exchange for simplicity.

[For example], your boss keeps asking you to explain your whole plan in three Powerpoint slides. The VC who allocates one minute to understand why your business will work has done everyone no favors. The blog reader who clicks away after a paragraph wasted his time visiting at all.

Skip the complicated, time-consuming part at your own risk…If it were obvious, everyone would do it. Wait, that’s too simple. How about this: Nuance and subtlety aren’t the exception in changing human behavior. They’re the norm.

A great example of how some miss understanding trend following by avoiding the subtle? They see one losing month and panic. If you work with that type of quick judgement you would be better off taking the blue pill and going back to sleep. Seriously! That excerpt connected well with this article sent by a reader in Australia that pumps the mistaken notion that investors can predict trends:

He’s adapted Nate Silver’s model very unscientifically to the global news cycle, using it to compile a handpicked store of knowledge, which he then aggregates to get a feel for where markets are heading.

The system requires at least five or six different news sources ranging across left to right leanings to provide the sort of radar that will give an accurate fix.

You may think you don’t have time to manage this, but there are apps that make it easy. Pulse is one I use because it enables the collection and collation, in chronological and subject order, of top news of the day from nominated sources. My friend’s favourites include Salon, Slate, The Atlantic, Bloomberg, CNN and Huffington Post.

He spends part of every morning trawling through headlines and reading only what he deems relevant to provide a snapshot of where the world is at any given moment. Over time this has helped him develop an accurate read on how he might reposition himself across sectors.

“If you’re reading a variety of news sources, you definitely start seeing trends, especially as everyone’s saying the same thing just in different ways,” he says. Lots of cautionary stories generally mean something bad is about to happen.

“If you’re hearing the same thing from multiple sources, that’s generally when something’s going to happen,” he says. “Which is why I’m out of stocks. There’s no way they’re going to stay where they are. They have to come down.”

Isn’t this akin to timing the market?

“No. I’m just trying to predict a medium- to long-term trend. If you want to get rich quick, this isn’t the way to do it because it’s very macro.”

He admits his method is not totally straightforward, and that there may be quite a wide margin for error depending on nominated reading material and how clever the reader is it at distilling it. But do it for long enough and you will get better at it.

Read, absorb, think and learn. Then do it again, then again. And eventually you’ll be smarter, too.

If you think tracking news sources to predict market trends might possibly make you rich, then you will probably get exactly what you want from the process. What is that? To have the feeling of losing money! For those of you who want the subtle from me, the nitty gritty, read.

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