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Author: druce Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 103  
Subject: Trend Following, by Michael Covel Date: 1/2/2005 6:13 PM
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The best analogy for investing this merry contrarian has encountered is by former Acorn fund manager Ralph Wanger. The investor is like a zebra on the savannah. You can graze where all the other zebras do, and you'll eat grass that has been well trampled and picked over by every other zebra. Or you can venture away from the herd, and eat fresh untrampled grass. The farther away you venture, the better the eating. But the more likely a lion will make you lunch.

Trend-following is one strategy to find fresh grass. The idea is, whenever the herd starts moving, try to get out in front. But stay close, so if it changes direction you don't get caught out in the open. If the herd generally tends to keep going the same direction, and you're quick to get in front, you'll eat lots of fresh grass without straying far enough to get separated from the herd and eaten. Of course, if it frequently changes direction you'll exhaust yourself and rarely be in front for long.

A posse of traders like Paul Tudor Jones and John Henry, owner of the Red Sox, have made huge fortunes on strategies that have a large trend-following component. I think it works for two reasons. Number one, there are more big trends than people expect. And when there's a big change in the world, most people take time to believe it and react. The biggest money is the most slow to change direction. So if you're nimble, and hop onto everything that looks like a trend, and cut your losses when you're wrong you'll lose a little bit on a lot of trades, but you'll catch those really big moves. But it tends to be risky. Even incredibly successful trend-followers have had stomach-churning drawdowns. Those who are quick and willing to take big risks have an edge. But occasionally they will be lunch.

A bible of the trend-followers is Michael Covel's Trend Following. I have mixed feelings about this book. Unlike many, it's not all pseudoscience and gobbledygook. You will get a sense of how trend followers think. But a little knowledge is dangerous. Too often, it feels like a fad book designed to sell courses. But if you know something about trading and investing, you will learn a thing or two.

Here's a doozy (p. 89): "if your trading strategy is based on benchmark comparisons, it won't matter whether you are a talented trader, since your decisions are limited to boundaries defined and set by the averages. Why would any trading skill be relevant?" Huh? If your decisions outperform the index or reduce risk vs. the index, then you're a good trader. End of story. Apparently a trend-following CTA/hedge fund is anyone who can get people to pay a performance fee for outperforming cash despite taking enormously higher risk.

On p. 200 "buy and hold" is declared a simplistic irrational security blanket. Apparently Warren Buffett is a fool for not selling some of his stocks when they ran into downtrends. Of course, "the trend is your friend" can be a simplistic mantra too. Large asset managers, with say $10B of Coke stock, making major allocation decisions, are exactly what make trend followers a lot of money. If Warren Buffett is offered as an example of what not to do, what would be a good example?

Trading is not a zero-sum game, contrary to the repeated assertion (for instance, p. 103). Well, in an accounting sense it is. In a poker game, if you don't win a given pot someone else does.

But a bull market is like a poker game with no rake and lots of new players and money coming in. (In a bear market, it's a steep rake and nobody playing but card sharks.) It's a growing pie. Growing GDP and national wealth is the sun that fuels the investing ecosystem. The markets do their part to create wealth because they let people take risks they might not otherwise take. If there were no public markets, you wouldn't have VCs giving entrepreneurs capital for a shot at an IPO. Is the VC a sucker for selling some Google to the public when the trend is up? No, it's win-win. The VC gets the cash to invest in the next startup, the hopeful buyer gets the prospect for a superior risk/return. If the market was really a zero-sum game in the long term, considering all the capital and intellectual resources it ties up, might as well shut it down.

Like any other type of trading, few are smart enough and disciplined enough to be good trend followers, and the markets spare no effort to destroy your discipline. This book is a good look into the mindset of trend followers. One suspects that it's not just ideology and guts, but a lot of technical skill, risk management, and maybe even some fundamental analysis (horrors!) that made the fortunes of the most successful traders. The important thing is to find an edge, and a way to apply that edge that works for you. You might not end up owning the Red Sox, but you won't be lunch.

Related websites:

MichaelCovel.com
Trendfollowing.com
Turtletrader.com
OriginalTurtles.com
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