Trend Following. Ritholtz Barry

the result of my near 20-year hazardous journey for the truth about this trading called trend following. To this day it still fills a void in a marketplace inundated with books about value investing, index investing, and fundamental analysis, but lacking few resources to explain how David Harding made his billion-dollar fortune with trend following.

      Out of the gate let me break down the term trend following into its components. The first part is trend. Every trader needs a trend to make money. If you think about it, no matter what the technique, if there is not a trend after you buy, then you will not be able to sell at higher prices. Following is the next part of the term. We use this word because trend followers always wait for the trend to shift first, then follow it.12

      Every good trend following method should automatically limit the loss on any position, long or short, without limiting the gain. Whenever a trend, once established, reverses quickly, there is always a point, not far above or below the extreme reached prior to the reversal, at which evidence of a trend in the opposite direction is given. At that point any position held in the direction of the original trend should be reversed – or at least closed out – at a limited loss. Profits are not limited because whenever a trend, once established, continues in a sustained fashion without giving any evidence of trend reversal, the trend following principle requires a market position be maintained as long as the trend continues.13

      A big reason this conceptually works is seen in the wonky-sounding Bayesian statistics. Named for Thomas Bayes (1701–1761), the belief is the true state of the world is best expressed in probabilities that continually update as new unbiased information appears, like a price trend that keeps updating and extending. New data stays connected to prior data – think of it chain-ganged together. Random dice rolls this is not.

      Trend following thus aims to capture the majority of a connected market trend up or down for outsized profit. It is designed for potential gains in all major asset classes – stocks, bonds, metals, currencies, and hundreds of other commodities. However straightforward the basics of trend following, it is a style of trading widely misunderstood by both average and pro investors, if it is known at all. Academic literature and real-world investors, for example, have put forth a host of strategies that, on the surface, appear unique, but at a high level they are all related to trend following.14

      That classic trend wisdom has long failed to be understood in academic circles – that is, until very recently. Notable voices in the academic community have come around to agree momentum exists – the source of trend following profit – but to confuse matters they describe two forms of momentum: time series momentum (i.e., trend following) and cross-sectional momentum (i.e., relative strength). I don’t see a connection between the two, and I can guess carving out business and academic niches for assorted reasons is in play, but I do know which strategy has produced decades of real performance proof, and it’s trend following.

      The desire to enlighten this state of confusion is what launched my original research and ignited my passion, going all the way back to 1994. My plan was to be as objective as possible, pulling research data from wide sources:

      ● Month-by-month trend following performance histories.

      ● Hundreds of interviews conducted with subjects from top traders to Nobel Prize winners.

      ● Published interviews from dozens of trend followers over the last 50 years – details not found on Google.

      ● Charts of winning markets traded by trend followers.

      ● Charts of historical markets seen across financial disasters.

      If I could have utilized only data, numbers, charts, and graphs showing extreme trend following performance data, that would have been perfect – it is, after all, the raw, unassailable data.

      Yet without a narrative explanation few readers would appreciate the ramifications of data mining. Robert Shiller has said “that there is a narrative basis for much of the human thought process, that the human mind can store facts around narratives, stories with a beginning and an end that have an emotional resonance. You can still memorize numbers, but you need stories. For example, the financial markets generate tons of numbers – dividends, prices, etc. – but they don’t mean anything to us. We need either a story or a theory, but stories come first.”15

      Foundationally, my approach to researching and writing Trend Following became similar to the one described in the book Good to Great, in which researchers generated questions, accumulated data in an open-ended search for answers, and then debated it all – looking for stories, then for explanations that could lead to theories.

      However, unlike Good to Great, which was about well-known public companies, to this day the strategy of trend following is still built around an underground network of relatively unknown traders who, except for the occasional misguided article, the mainstream press virtually ignores – and that has not changed in my 20 years. What I attempted with my first edition of Trend Following and with this newest edition is to lift the veil on this enormously successful strategy – how trend followers trade and what can be learned that anyone can apply to their portfolio for profit.

      Throughout this effort I avoided institutionalized knowledge as defined by Wall Street banks, brokers and typical long only hedge funds. I did not start with JPMorgan Chase or Goldman Sachs. Instead I asked questions across all types of sources and then, objectively, doggedly, and very slowly – and even through some Deep Throat help – answers that made intuitive sense were revealed.

      If there was one factor that motivated me to work in this manner, it was childlike curiosity – where you rip the toy open to the find the motor and locate the essence. For example, one of my earliest curiosities was about who profited when a famed British bank collapsed, making the front cover of Time magazine. My research alone unearthed a connection between this bank and a wildly successful trend follower now worth billions. This trader’s trend-trading track record had me wondering, “How did he discover trend following in the first place?”

      I also wanted to know who won when a two-billion-dollar hedge fund collapsed and almost sank the entire global economy. Why did the biggest banks on Wall Street, the so-called smart guys in charge of your retirement, invest $100 billion in this fund when there was so much obvious risk? Further, when I contrasted typical Wall Street losses during October 2008 to what trend following made during the same time in the great zero-sum game, it was hard to grasp why few market players were aware of the strategy. Other questions appeared:

      ● How does trend following win in the zero-sum game of trading?

      ● Why has it been the most profitable style of trading?

      ● What is the philosophical framework of trend following success?

      ● What are the timeless principles?

      ● What is the trend following view of human behavior?

      ● Why is it enduring?

      Many trend followers are still reclusive and extremely low key. One who has beaten the markets for over 40 years works out of a quiet office in a Florida coastal town. For Wall Street this approach is tantamount to sacrilege. It goes against all the customs, rituals, trappings, and myths embedded in so-called success. It is my hope my narratives, backed by data, will correct misconceptions of winning as a harried, intense workaholic posted 24/7 in front of 12 monitors while downing Red Bull.

      One of my sources who helped break apart this puzzle was Charles Faulkner. He observed elite traders are almost “floating above the world, seeing it from a different perspective than the rest of other market participants.” His insights go straight to the core:

      ● It doesn’t matter what you think; it’s what the market does that matters.

      ● What matters can be measured, so keep refining your measurements.

      ● You don’t need to know when something will happen to know that it will happen.

      ●

12

Van K. Tharp, Trade Your Way to Financial Freedom (New York: McGraw-Hill, 1999).

13

Richard D. Donchian, “Trend-Following Methods in Commodity Price Analysis,” Commodity Year Book (1957), 35.

14

Ari Levine and Lasse Heje Pedersen, “Which Trend Is Your Friend,” Financial Analysts Journal 72, no. 3 (May/June 2016).

15

Miles Kimball, “Robert Shiller: Against the Efficient Markets Theory,” Confessions of a Supply-Side Liberal (blog), April 14, 2014, http://blog .supplysideliberal.com/post/82659078132/robert-shiller-against-the-efficient-markets.