One of the delights of the festive season (for me at least) is that without the distraction of the usual day to day things I can get the opportunity to reflect on things a little more. As is often the case that means the last thing you read, in my case Michael Covel’s Trend Following (my review here).
I should start by saying that I believe that trend following is a viable investment strategy. I’m not going to try to convince you, or say that its a simple strategy to follow, or think like Covel that its the only viable strategy out there. I am encouraged in this by its agnostic approach towards markets – the strategy doesn’t say the market is trending, or going to a certain target value. All it says is that markets trend, and trend followers just jump on for the ride with the condition about being very disciplined about getting off when they are wrong.
But, having said that I don’t believe trend following will ever be popular. And the reason has nothing to do with returns and all to do with volatility. Even successful trend following has large drawdowns. Large and long – frequently months and often for a year or two. However we live in a world of quarterly reporting, or often monthly or more frequent. Rarely is it annual, never longer. Which in one sense is fine – this is how most people think. They are very good at looking forward a week or a month or a quarter. We’re not so good at looking forward a year and really bad at longer time frames. This is the point that its easy to trot out the glib comments about how the long-run is a series of short runs and Keynes quote “in the long-run we are all dead.” But that misses the point.
It is slightly unnatural to tolerate short-run bad performance – we question whether the system is broken, or if a manager has ‘lost it’ (as if we had an idea what ‘it’ was in the first place) or if market conditions have changed irrevocably and will never return to the way they were before. We find it hard to inactive – if things aren’t working we feel we should do something to fix them. Which is why people sell out of investments just before they go up. But trend following suffers from a problem (as in some ways equities do) – the strategy works by taking lots of small losses offset by fewer large gainers. So by its nature its vulnerable to drawdowns. Finding people who can both understand that and tolerate are thin on the ground, which is why despite Covel’s evangelism it will never be popular.