Jul

31

UptrendI submit four hypothesizes in defense of trendfollowing. I hope these thoughts provoke a discussion that is broadly useful.

1) In hindsight, all profitable investments can be characterized as either trendfollowing or positive carry. It’s simply a function of timeframe and definition. If Anatoly Veltman “catches a falling knife” in Crude, and it bounces, he had a successful trendfollowing trade in an hourly context. When Vic and Laurel state that stocks have an upward bias over time, they are making a trendfollowing statement in a multi-year timeframe. When Warren Buffet buys Coke and holds it for 30 years, it’s multi-decade trendfollowing. When Bear Stearns buys a zillion dollars of mortgage backed securities on repo, it is positive carry. (Prior to the margin call, that is.) The inherent superiority of trendfollowing systems over positive carry, intuitive, and countertrend systems is the average person’s ability to define risk a priori by using statistically appropriate stops and then the ability to “get lucky” by not limiting potential profits.

2) The rationale and methodology that one uses to enter a trendfollowing trade is not particularly important so long as it’s consistent, fundamentally sound, and applied with discipline (so as to allow getting "lucky") in the relevant timeframe. Whether you use a simple moving average or some fancy neural network matters less than the ability to survive repeated mistakes: Humility and Survivability. (I readily admit that a portion of my assets sit in an S&P500 index fund, because the trendfollowing time horizon for that money is decades. And the “stop-loss” for my S&P500 fund is zero on the S&P!)

3) Diversification across timeframes is just as important as diversification across asset classes. Again, the methodology that one uses at each timeframe is less important than the consistency of the approach. I’ve noticed that many of the very best trades are multi-week; perhaps because the attention span of many market participants is just a few days?

4) Lastly (and acknowledging the contradiction with everything else above) if you begin to fade a market when it is two or three sigmasaway from its recent mean price (in the relevant timeframe) and you pursue a geometric (Martingale) strategy, there is 100% certainty of profit. Unfortunately one can do this only in a size which is tiny, or eventually face the gambler’s ruin dilemma.

Hence my contention that all successful investors are either trendfollowers or geniuses. But both must use a consistent methodology that fits their temperament and Weltanschauung.

Robert Mahan replies:

Your definition of trendfollowing is much too broad. It seems to include every trade which goes the direction of the market. When most people say “trendfollowing” they mean a strategy based strictly on price momentum. Buffett's buying and holding Coke for 30 years isn’t the same thing. He might have held Coke had it gone down for 30 years on the basis that the “value” was getting constantly more attractive. I will grant that going long equities due to the belief in a perpetual upward bias is surely a form of trendfollowing.Trendfollowing can’t work as a long-term strategy unless the market trends more often than would be expected by a random walk. Does it?

As you say, you can always “get lucky” trendfollowing. You are less likely to get lucky with a lot of short term trading, because the vig will erode your “luck." But to paraphrase an old quote, getting lucky is hard work. 

Archives

Resources & Links

Search