I came across a “risk capacity” survey online. One of the questions with answer choices:

How would you rate your knowledge about investing in general and more specifically, the relationship between risk, return, and time?
A. significantly below average
B. below average
C. average
D. above average
E. expert

How does it help to pose this question to investors? The firm that poses the above question also makes these assertions on their website:

1. It is virtually impossible to beat a market over time through active investing.
2. Indexing is backed by Nobel laureates who have provided unbiased, rigorous, empirical research, most notably the Modern Portfolio Theory.
3. Stock pickers are analogous to gamblers who rely on feelings and emotions when making bets.
4. Time pickers or market timers move money in and out of different investments in an attempt to profit from short-term cyclical events, which is a futile endeavor.
5. Manager picking is not a reliable practice because the past performance of money managers does not predict their future performance. Star money managers fall from their stature sooner or later, since their stellar performance is attributed to Lady Luck rather than skill.

Whomever wrote the above 5 points has not read Market Wizards, Fortune’s Formula or Trend Following.

Trend follower Campbell and Co. from their web site offers this graphic with this explanation:

“The Effect of Adding Campbell Composite to a Hypothetical Portfolio Consisting of Stocks and Bonds Quarterly Returns from January 1972 – October 2005 (estimates)”

From a portfolio level perspective, many have a hard time digesting the fact that a “risky” investment added to an existing portfolio of stocks and bonds can actually increase return and reduce risk.

This audio excerpt (MP3) is from the new book Taming the Lion by Richard Farleigh.

Brett Steenbarger outlines an interesting aspect of bodybuilding called ‘train-to-failure’ (PDF). An excerpt:

“The vast majority of people live their lives the way uninformed athletes train: they take on too many demands, none of which are sufficiently intense to take them to failure. Theirs is the equivalent of lifting a twenty-pound barbell for hours on end. They become tired, but not strong. By the time they get old, they are chronically tired, and then retire from all demands. For many, retirement is an exercise in mental, physical, and spiritual deconditioning.”

Download PDF.

Feedback:

“Hello Michael, I have just finished reading your book and have found it to be very informative and would recommend it to anyone as one of my top 3 trading books. The trend following method I currently use is essentially a combination of two methods discussed in Appendix A of your book (“Trend with Pattern Entry” and “Donchian Channel”). On the very last page of the book there is a coupon to fill in to get a free trend following CD ROM. Is this available for people located overseas (I am located in Australia)? Once again, thanks for writing a terrific book. Have you / do you ever intend to come to Adelaide, South Australia? Regards, John Porton.”

Yes, the free coupon offer in the new edition of Trend Following is available for everyone across the planet. I have not been to Australia yet, but will be making the trip in the near future!

I was forwarded an article on year-end portfolio “rebalancing”. First it said:

“Lighten up on longtime winners like small stocks, gold shares and real-estate investment trusts.”

Then it said very next line:

“Make sure you have a full weighting of growth stocks, blue chips and Japanese shares — and don’t be too quick to trim your positions if they roar ahead.”

These statements contradict each other. How and why should you lighten up on longtime winners (I assume they are still winners), but also at the same time not trim positions that are roaring ahead?

Feedback from today:

“…what do you think of using weekly and daily data to ensure that a trend is happening?”

Trend following is definitely practiced using daily bars. I know some past and current trend followers who use weekly bars too. However, isn’t the real key still to answer the 5 questions first?

Feedback today:

“Wanted to add a comment to the 12/20 comment on shorter trends. I can relate. In my opinion, and with 7+ years experience, I believe what constitutes “a trend” is much like beauty, it’s in the eye of the beholder. It is very subjective…I, for instance, perceive markets in terms of “trends” that generally last from several days to several weeks. While I may trade a particular market 12 to 15 times in a year, the LT trend followers may only trade it once of twice.”

Short term trading is doable, but you better be Jim Simons or Toby Crabel. And you better figure out how to handle commissions and execution costs that will always be there to eat away profit. I add a brief new comment on this in the new edition of Trend Following in the appendix.

Feedback received today:

“Hi, I was just experimenting using different moving averages to react to price movement in equities and futures. I notice that in your book, you mention only exponential moving averages of different time lengths. What do you think of using moving averages with different calculation methods (say exponential and triangular or time series) in order to track recent price movement in a stock as opposed to price movement in the past? It seems like that would be a pretty good way to track breakouts. Thanks. Joe.”

I look at these issues in a different way. The key is answer the 5 questions presented in Chapter 10 of my book:

1. How do you determine what market to buy or sell at any time?
2. How much of a market should you buy or sell at any time?
3. How do you determine when you enter a market?
4. How do you determine when you exit a losing position?
5. How do you determine when you exit a winning position?

If after testing you determine that your variation or choice of moving average works to help you answer those 5 questions (to meet your personal goals of profitability, drawdown, etc.), then you are on to something. If it doesn’t work, lesson there too. But don’t get fixated on the entry indicator…

Feedback on “shorter-term” trends:

“Michael: I have read the older version of Trend Following and am working to apply the knowledge you conveyed so well in it. I am a definite believer in trend following and its benefits. With that being said, I would like to offer one piece of ‘information’ that I have acquired through reading a couple of dozens books on trading and my somewhat limited experience trading. For some reason, perhaps that I am 55 and my brain isn’t as fast as it used to be, I came away from reading your book with the following phrase in my mind: “Long-term trend following.” Admittedly, your book does not really use this phrase. You simply recommend ‘trend following.’ The reason I raise this issue is that, trend following does not, by definition, have a specific time frame inherent with in its’ ‘methodology.’ It does not have a defined length, or even an intoned length of trade. My mistake in interpreting ‘trend following’ as ‘long-term trend following’ caused me to stay in trades after a seemingly ‘short-term trend’ (meaning less than a few months) had run its course. Because I had the concept of ‘long-term trend following” in my mind, I was looking/expecting trades to last for many months and perhaps into years. While there are trends that will meet these criteria, there are many, profitable, ‘trend-following’ trades that last only a few days or a few weeks depending upon the future/stock that is being traded. Once I recognized this ‘long-term’ definition error in my thinking, I have been exiting some ‘trend-following’ trades more quickly than before, and have, as a result, often ‘saved’ substantial profit that I was previously letting slip away while I waited for the ‘long-term’ time period to pass. I share this with the hope that it might help others who might suffer from the same misconception that ‘trend following’ has some pre-defined aspect of time built into it. It doesn’t. Just follow the trend over the time period for which one’s analysis applies, and get out when that trend says it is done. And, of course, cut losses short. Thanks for sharing your knowledge with others. Sincerely, H. Richardson”

How do you determine the “time period for which one’s analysis applies”? The trend followers that I have written about and the trend following I describe is thought of as long-term trend following. That’s how they define themselves and their trading. There are the few super traders (i.e., Simons, Crabel) who can trade very short time frame trends with success, but the average trader has no shot in my opinion in so-called “shorter trends”. Shorter trends require much more in terms of execution and commission for success.

Brett Steenbarger in a recent article titled Coping With Risk and Uncertainty offers:

“What constitutes a source of stress is highly dependent upon our perception. If we define something as a threat, we will experience it as threatening, and that will trigger a stress response. For some people, public speaking is an everyday activity, not to be feared at all. It might even be something enjoyable. Others view public speaking as a potentially humiliating event. Their perception of threat triggers the stress response that we call performance anxiety. Cognitive psychologists, however, remind us that it is not the public speaking event itself that is generating the anxiety, but rather our processing of that event. Take away the perception of threat and the anxiety diminishes.”

This paragraph struck me. How many times have you ever heard someone say, “that’s too risky”, when talking about trading? Traders will have different perceptions of risk depending on their “processing” or “understanding”. Saying that something is “risky”, without further explanation or discovery, is plain lazy. Thanks to Dr. Steenbarger for the pearl of wisdom!

Even though James Altucher refuses to recognize trend following as viable, I do appreciate and thank him for his mention of my blog and book Trend Following in his ‘RealMoney.com Blog Watch’ for December 17, 2005.