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The Joys of Trend Following, by Victor Niederhoffer

One hates to be a sore winner, or to risk becoming hubristic, and one knows that he will risk the fate of Cassandra in the home of Agamemnon, but in view of the consistency with which I have cast doubt on the continuity and wisdom of trend following, it does seem appropriate to retrospect a bit. First one notes that Practical Speculation contains a chapter on the statistical reasons that trend following doesn’t work. Same for Ed Spec. And numerous columns in MoneyCentral and posts on this site limned this theme.

One also notes that the various trend following clubs and associations consider me a complete moron and worse, and love to point out that my ability to run a hedge fund (have I mentioned my disaster in 1997 recently?) is equal to my knowledge about trend following. And yes, I have been known to take a position against a trend and as far as I know, never with one in many, many tens of thousands of trades I have put on.

Thus, the news that at least two of the three greatest gurus of trend following are down some 30 to 40% so far this year (the southern one after a 9% rise), is not surprising to those who have followed the various warnings, admonitions and guidedictions from Collab and me. One hopes for everyone’s sake that the trend followers will bounce back from this drawdown as they have many times in the past.

Also reassuring, at least on the surface, is the review of research from some of them that studies of market moves over the last 100 years show that the time to add more to the trend following idea was after periods of the greatest drawdowns. But despite the hopes for success, and one must note that he is indeed a friend, fellow traveler and supporter of at least one of the three greats (and an admirer of at least one of the others for his business acumen and hard work following his community college education), one has his doubts concerning the reassuring conclusions that emanate from the research.

The main reason for doubt is that what happened 100 years ago is not that relevant to what will happen tomorrow. Indeed, to the extent that many markets were not big enough in the past for active trend following to play a substantial part in the market's dynamics, one feels that the relevance of even recent years is very minor. Furthermore, even if there were relevance, the principle of ever changing cycles (see bacon), would make even relevant statistically significant results somewhat suspect for the future. However, as we have often pointed out, because of the small number of independent observations involved in the trend following results (all markets are highly correlated), and some of the trend followers change two or three times a year or less , the statistical significance of the past results and the confidence intervals to be drawn from them seem to us vastly overstated , even assuming that the future moves were drawn from distributions similar to the past.

But over and above all this, one notes the following. And this reflection is inspired by a recent visit one had with the former convertible arbitrageur and now buyer of undervalued companies, Mr. C.I.

Yes, trend following and buying volatility seem to have worked in recent years. But to what extent should conclusions for the future be based on a repeat of such things as the 1987 crash, the 9/11 tragedy, the long term credit debacle, the closing of the S&P in 1997 that gave me the final death blow, or a repeat of the July 2002 market swoon of 25% when personal tragedy struck Vic and his partner.

Along the same lines, granted that there has been a 20-year secular rise from 16% long term bond rates and 10% treasury rates in the cardigan years to the 4's and 2's today. Granted that many markets in fixed income and or those related to them, like stocks for example, would have shown fantastic returns to trend following during this period. Why should that give one confidence that following a similar method would work today? Granted that stocks suffered a three-year blood bath in the new century oughts, and they did something similar in the 1930s, and this allowed trend following in stocks to look good during those periods. Why should that lead to a theory that because it worked in the past, one should be pleased to commit much to it in the future?

One reflects on these thoughts with a feeling of humility and sadness. One's guard is great that there is negative serial correlation in the actual Results of trend followers (when adjusted properly for survivor bias). One's hope is that the market will not deal one or the other of us another terrible blow. 

Grandmaster Nigel Davies Responds:

I hypothesize that one aspect of the personality test I presented to the list may relate to trend following, ie whether someone is objective and logical ('head') or whether they tend to consider the feelings of others ('hearts'). I suspect that it's much more difficult for someone who likes to get on with people and is diplomatic and considerate to go against the crowd and enjoy taking their money. Indeed the 'heads' heavily outnumbered the 'hearts'.

Could it be that we are predisposed to a particular way of investing by who we are? Certainly one wouldn't identify the pink-trousered chairman as a trend follower unless these were the fashion.