When Henry speaks of decisions that may be subject to behavioral biases, he is referring to those who make their buy and sell decisions on fundamentals, the current environment, or any number of other whatever factors. It’s a never-ending parade of data they can supposedly sift through and utilize. In other words, they use their discretion – hence, the use of discretionary to describe their approach.
Decisions made at the discretion of the trader can be changed or second-guessed nonstop. These discretionary gut-trading decisions will be colored by personal bias. I have yet to see a multi-decade track record produced by gut trading. It’s 100 percent fantasy. Many imagine the process is like a fighter pilot strapped into the cockpit armed with an instinctive feel, or even an innate gift. It’s not that.
Now, a trader’s initial choice to launch a trading system is discretionary. You must make discretionary decisions such as choosing a system, selecting your portfolio, and determining a risk percentage (some would argue even these aspects can be made systematically too). However, after you’ve decided on the system-orientation basics, you can systematize these discretionary decisions and make them mechanical.
Mechanical or systematic trading systems are based on objective rules. Traders put rules into computer programs to get in (buy) and out (sell) of a market. A mechanical trading system eliminates emotional vacillation. It forces discipline to stick with the process. If you rely on mechanical trading system rules, and break them with discretion, you are guaranteed to go broke.
Henry puts into perspective the downsides of discretionary thinking: “Unlike discretionary traders, whose decisions may be subject to behavioral biases, we practice a disciplined investment process. By quantifying the circumstances under which key investment decisions are made, our methodology offers investors a consistent approach to markets, un-swayed by judgmental bias.”40
Maybe it is rigid to say it’s against the rules to use a little discretion. You might think, “How boring to live like a CPA.” Where’s the fun if all you ever do is follow a mechanical model? Successfully making fortunes isn’t about excitement. It’s about winning. A researcher at Campbell & Company, one of the oldest and most successful trend following firms, is adamant: “One of our strengths is to follow our models and not use discretion. This rule is written in stone at Campbell.”41
Trend trader Ewan Kirk adds:
Systematic trading involves coming up with a statistical model of the markets. Assuming that model has worked in the past, and that you have developed and researched and tested your model correctly, then your hypothesis is that it’s likely to keep working in the future. So the actual execution of trades is just continuing to follow what the model says. Now that sounds quite mechanical. In fact, it’s no different than the way any good investor works. Why would you invest with Warren Buffett? Because, over the past 30 years, Warren Buffett has made money, and you’re assuming that’s going to continue in the future. Conceptually, that’s no different than what we do.42
Traders Todd Hurlbut and Ted Parkhill further note the perils in discretion: “We are systematic. We have seen examples where managers either start to doubt and then start tinkering so there is what today is called style shift or worse where a manager dramatically changes the approach to what could be called style ‘flip.’”43
Hiding in Plain Sight
Trend following, and assorted derivatives of price-based trading, is not a new concept. It goes back across names like David Ricardo, Jesse Livermore, Richard Wyckoff, Arthur Cutten, Charles Dow, Henry Clews, William Dunnigan, Richard Donchian, Nicolas Darvas, Amos Hostetter, and Richard Russell. Believe it or not, it literally goes back centuries, with data to prove it (see Chapter 19 and 20 in Section III, “Trend Following Research”).
AQR’s Cliff Asness clarifies: “Historically, it’s been a strategy pursued primarily by futures traders and in the last 10–20 years by hedge funds. The trading strategy employed by most managed futures funds boils down to some type of trend following strategy, which is also known as momentum investing.”44
Even traders not typically associated with trend following eventually find their way. In Hedge Fund Market Wizards, Jack Schwager asked Ed Thorpe, an American mathematics professor, author, hedge fund manager, and blackjack player best known as the “father of the wearable computer,” if he believed “there are trends inherent in the markets?” Thorpe replied: “Yes. Ten years ago, I wouldn’t have believed it. But a few years ago, I spent a fair amount of time looking at the strategy. My conclusion was that it works, but that it was risky enough so that it was hard to stay with it.”45
Thorpe noted he used trend following, too. And so it goes; price-based trend strategies discovered by new and old generations at different times. Salem Abraham, now an established trend following veteran, began researching the markets in his early twenties by asking a simple question: “Who is making money?” His answer was “trend followers” and his journey began.46
Still, not many have made the journey. During the Dot-com era of the late 1990s, throughout the Fed-induced S&P run-up after March 2009, and even today into 2017, many with zero strategy have made money in other ways, so trend following becomes a blip on the radar screen – seemingly not so important.
And since trend following has nothing to do with high-frequency trading, short-term trading, cutting-edge technologies or Wall Street hocus pocus nonsense, its appeal is universally lost during extraordinary delusions unleashed inside the madness of crowds – that is, until bubbles pop. Trend following is not sexy until after the masses get poached and bleed out.
Nonetheless, if you look at how much money trend following has made before, during, and after assorted market bubbles, it becomes far more relevant to the bottom line of astute market players.
Yet, even when over the top trend following success is thrown onto the table, skeptical investors can be tough sells. They might say markets have changed and trend following no longer works. But philosophically trend following hasn’t changed and won’t change, even though markets might not always cooperate.
Let’s put change in perspective. Markets behave the same as they did hundreds of years ago. In other words, markets are the same today because they always change – humans are involved, after all. This behavioral view is the philosophical underpinning of trend following. A few years ago, for example, the German mark had significant trading volume. Then the euro replaced the mark. This was a huge change, yet a typical one. If you are flexible and have a plan of attack – a solid strategy – market changes, like changes in life, won’t kill you. Trend followers traded the mark; now they trade the euro. That’s how to think.
Accepting that inevitability of change is an initial step to understanding. One trend follower elaborates:
But what won’t change? Change. When a period of difficult performance continues, however, most investors’ natural conclusion is that something must be done to fix the problem. Having been through these draw downs before, we know that they are unpleasant, but they do not signal that something is necessarily wrong with the future. During these periods, almost everyone asks the same question in these exact words: “Have the markets changed?” I always tell them the truth: “Yes.” Not only have they changed, but they will continue to change as they have throughout history. Trend following presupposes change. It is based on change.47
Markets of course are built by design to go up, down, and sideways. They trend or chop. They flow or don’t. They are consistent, then they surprise. No one accurately can forecast a trend’s beginning or end until it becomes a matter of record. However, if your trading strategy is designed to adapt, you can take advantage of changes:
If