A client’s bank sent an over payment for one of my products. An over payment of $6000! His feedback once we got it all sorted out for him:
—
Hi Mike,
Hope your season festivities met with your expectations and more. I received the reversed payment from you on December 22. Thank you. The paragraph below can be included in a future blog if and when required:
Mike, there are people out there who would probably not have gone to the time and effort to resolve the over payments and some who would not have bothered to return them. Thanks for your valuable time, effort, I dare say money and most of all your honesty, have great year.
The turn of the year is when traditional long only money managers state their predictions for the year ahead. Equity managers may be bullish if stocks are cheap or central bankers are expected to flood the markets with money, for example. Or they may be bearish if value is perceived the other way. It may not be an easy task, but the manager can generally make a guess based on a reasonably sound and intuitive argument. For a trend follower, however, it really is hard to answer the question in a manner that would satisfy most people.
The reason for this originates in how trend followers trade…trend followers are typically long when a market is rising and typically short when a market is falling. This is achieved through a systematic, non-discretionary process where computer algorithms analyse historic data in order to identify trends lasting anything from a few days to multiple months, with an average of around two months. Of course, individual markets may not trend all the time, so trend followers diversify by trading a wide variety of markets over many asset classes. The intention is that, as long as these markets are lowly correlated, the trend-following net is cast as wide as possible, and trends are captured wherever and whenever they occur. The technique is applied to the most liquid instruments available, meaning the strategy itself is highly liquid.
So trend followers do not care whether markets go up or down as they can potentially profit either way. Trend followers do not care which markets trend, as they typically trade a range of asset classes. Trend followers do care about persistence. As long as trends last at least a couple of months, the typical holding period of a medium term trend follower, we are generally happy.
Our prediction for the year ahead is therefore based on the persistence of market moves, and what can give us any confidence in that? Quite a lot, as it turns out. First of all, there is theoretical grounding for the existence of trends through the field of behavioural finance, or because of the varying speeds of dissemination of information into markets for example. Second, and perhaps more persuasively, there is evidence of trends existing in markets for hundreds of years1. So although it may be difficult to think why trends may persist in the year ahead, history and theory are with you.
The differences in how traditional versus trend-following managers have to think about the year ahead is a manifestation of the different yet complementary approaches both take. As you might expect, different approaches lead to different return profiles.
…trend followers are typically uncorrelated to equities (and other asset classes for that matter) because trend followers can be long when prices rise and they can be short when prices fall. What is also clear is that when the S&P has its worst calendar years, trend following returns have tended to be strong. It would seem that when equity markets are in crisis, trends can be strong and trend followers can be profitable.
If you have been inundated with predictions from traditional managers for 2016, spare a thought for us non-traditional managers. We find it hard to give explicit catalysts for performance in the year ahead, and as such are reluctant to give forecasts…Trend following offers an uncorrelated return stream to equities, and can even perform strongly when equities are in crisis. Trend following is perhaps considered a non-traditional strategy but on these grounds it may well be a welcome addition to traditional portfolios.
A happy reminder of the efficacy of trend following.
Please enjoy my monologue The Force Awakens with Michael Covel on Trend Following Radio. This episode may also include great outside guests from my archive.
My guest today is Brett Steenbarger, a Clinical Associate Professor of Psychiatry at New York State University, author of “The Daily Trading Coach,” “The Psychology of Trading,” and “Enhancing Trader Performance.” His newest work is “Trading Psychology 2.0: From Best Practices to Best Processes.” He is a trading coach, psychologist, author, blogger, and stock index trader.
The topic is trading psychology.
In this episode of Trend Following Radio we discuss:
The emotional “buy in”
Checklists
Finding a smooth equity curve
Repeated performance vs. deliberate practice
The role of fitness and health in trading
The moment of now
Systems trading vs. discretionary trader
Relationship between volatility and volume
“The fantasy of easy riches collides with the reality of what you need to do to prepare to win and I think that creates quite a dissidence for many beginning traders and ultimately leads them to leave the field.” – Brett Steenbarger
Perhaps not surprising, trend followers have spent as much time observing and understanding human behavior as they have trading. Understanding human behavior and how it relates with markets is commonly referred to as behavioral finance.
Behavioral finance evolved out of a contradiction between classical economic theory and reality. Economic theory is based on the assumption that people act rationally, have identical values and access to information, and use rational decision making. The truth is people are irrational and seldom make completely rational decisions even if they think they do. I have had the good fortune to learn from some of the top minds in the field of behavioral finance. From Nobel Prize winner Vernon Smith to Charles Faulkner, my eyes have been opened. Faulkner outlined the core issues:
“The current proliferation of electronic technologies— computers, the Internet, cell phones, 24-hour news, and instant analysis—tend to distract us from the essentially human nature of markets. Greed, hope, fear, and denial, herd behavior, impulsiveness, and impatience with process (‘Are we there yet?’) are still around, and if anything, more intensely so. Few people have absorbed the hard neuroscience research that reasons arrive afterwards. That given the choice between a simple, easy-to-understand explanation that works and a difficult one that doesn’t, people tend to pick the latter. People would rather have any story about how a series of price changes happened than that there is no rational reason for it. Confusing hindsight with foresight and complexity with insight are a few more ‘cognitive illusions’ of Behavioral Finance.”
Faulkner is correct, but that doesn’t make his words easy. The problem is that by not accepting that truth, you will get into trouble one way or another, as Carl Sagan reminds us:
“It is far better to grasp the universe as it really is than to persist in delusion, however satisfying and reassuring.”
A few years after writing Trend Following I came across another great mind in the field of human behavior and psychology, Alan Watts. Consider some feedback from a listener:
Mike,
Thanks for turning me on to Alan Watts through your podcasts. Below is a link to an audiobook that I think you may find interesting, considering your interests in yoga and other eastern traditions. Andrew is a Lama (not a llama) and an old friend of mine: Here
Tell me something the “market” does not know. The idea that you can know enough about Apple, oil, GE, and gold to trade them all the same way may seem preposterous, but think about what they all have in common: Price.
Market price is objective data. You can look at individual price histories, without knowing which market is which, and still trade all successfully. That is not what they teach at Harvard, Wharton, Kellogg, Stern, Darden, or pick your favorite business school du jour.
However, the concept of price as the critical trading cue may be too simple for mass acceptance. For example, a prominent business anchor opined: “At some point, investing is an act of faith. If you can’t believe the numbers, annual reports, etc., what numbers can you believe?” A longtime financial reporter at Fortune magazine was also on the highway going the wrong direction: “If some of the smartest people on Wall Street can’t trust the numbers, you wonder who can trust the numbers.”
You can never trust those numbers—that is, the reported firm details—completely. Someone can always alter them (remember Enron had a fake trading floor). Beyond that, even if you know accurate balance sheet numbers, how does this help you determine when or how much to buy or sell?
The market is always right, and price is the only true reality in trading. If you want to make money in any market, you need to mirror what the market is doing. If the market is going down and you are long, the market is right and you are wrong. If the market is going up and you are short, the market is right and you are wrong. Other things being equal, the longer you stay right with the market, the more money you will make. The longer you stay wrong with the market, the more money you will lose.
You do not need to know anything about bonds. You do not need to understand different currencies. They are just numbers. Corn is a little different than bonds, but not different enough to trade them differently. Some people have a different system for each market. That is absurd. You are trading mob psychology. You are not trading corn, soybeans, or S&P’s. You are merely trading numbers.
Some feedback from a listener on price:
Dear Michael, I think that you have done a great work in explaining what trend following is. However, there are two great arguments that you have never faced:
1. You have always discussed price. I know that prices constitute a trend. Nevertheless, you should interview some of the main traders that [use] volumes. I would like to know how great traders interpret volumes as they are the first step for an incoming new trend. This study is lacking in all your work. It would be very helpful to know anything about that.
2. You have always talked about trends. It is correct. However, it is better to buy a stock that is likely to have a +200% uptrend than a stock that is only likely to have a +20% uptrend. So the questions is: how do great trend follower traders make their picks by relying their choice ONLY on prices and volumes?
I will wait for a polite answer of yours.
Kind regards,
[Name]
You can’t predict the next 20% v. 200% move. Impossible.
Volume? That is not the main topic of conversation in my trend following world.
