A lot has been written on value Investing in the last few decades. The Poster Boy (daddy) Warren Buffet has done a wonderful job in propagating and promoting it to an extent that now finally it is knocking on the curriculum of some early mover MBA colleges.
Not so much for the Other Proven Anomaly, TREND FOLLOWING.
I thought of writing this blog to bring our audience up-to to speed.
Eugene Fama, the father of Efficient market hypothesis, himself conceded to 02 anomalies in his otherwise full proof rational market theory.
He said momentum is the premier anomaly.
He had to, I mean try explaining the IT boom of 2000 with Efficient market hypothesis. EMH, just like black sch oles option pricing model or any other higher mathematics crap falls flat on their face in extreme situations, the fat tails.
It is in these FAT tails where these anomalies reside and value Investors exploit market over reaction to bad news which culminates into panic and herd instinct WHILE momentum players exploit markets under reaction to good news culminating into euphoria and again herd instinct.
Here are a couple of papers written on this subject showing the TREND FOLLOWING back tests ranging 100 years data. (Shift + enter to open in new window)
Trend following is Something Else, It is NOT Buy and hold, Not your typical technical analyses either. It is a system that declares that we cannot forecast and anybody who can is a blatant liar or a fool. It is a mechanical, back tested way of reacting to the market moves. It is long term in nature, the normal vicissitudes of market volatility does not bother it, however a big change in direction gets you out, if not SHORT.
Trend following is almost zen like, always in the moment of NOW. There is no future prediction. I am long right now and I will be long as long as long holds. No prize for guessing that this kind of system will lose a lot of money in choppy environments. The whole premise of trend following system is that one good trend pays for them ALL. A great trend following system can earn you a fortune by being right 28-30% of the time. Infact some of the trend following millionaires have a system which is below this percentage.
The MOST Important thing in trend following strategy is the POSITION SIZE, or how much to bet.
Please download and go through the paper written by Ed Seykota and Druz on this subject. This can be a beginning for you to write your Position size algorithm.
Another comprehensive back test was done by Wesley Gray of Alpha Architect where he showed the alpha generated by momentum over last 40 years. We interviewed Mr Gray, you can listen to the PODCAST here
Gary Antonacci of dual momentum is also doing some pioneer work in combining relative momentum and absolute momentum to generate Alpha. Click on the link above to see his work. We were privileged to interview him as well. Podcast coming soon.
Mystic wealth actually did a back test of relative strength strategy applied on Nifty, Gold and N100
One of the most celebrated Trend followers of our time is Ed Seykota who has made easy for the audience by singing a song on his 6 key steps to trend following system. Listen in
SIX SIMPLE POINTS
- Ride your winners. Once you have caught the trend, kill the urge to square off due to risk aversion bias, action bias etc and sit on your ass, Ride the Wave.
- Cut your losses. Once you are wrong, get out avoiding the sunk cost fallacy
- Risk management. Have Optimum bet size, not too big, not too small. There are old traders and bold traders but no bold old traders.
- Drawdowns are part and parcel of trading. Take your small losses with grace. People who avoid small losses get mother of a big loss that wipes them off.
- Follow the system. Have a mechanical rule based system, pull the trigger when a signal comes. Use of brain is required at the time of formulating a strategy (system 2), at the time of decision do not use brain because that will be (system 1)
- File the news. Price is the only indicator, All news and funny-mentals are priced in.
Some other prominent Trend followers who have made it big by just riding the wave are
You can see their envious performance and sources from here