Trading mentor Van Tharp once stated:

Perhaps the greatest secret to top trading and investing success is appropriate money management. I call it a ‘secret’ because few people seem to understand it, including many people who•ve written books on the topic. Some people call it risk control, others call it I diversification, and still others call it how to ‘wisely’ invest your money. However, the money management that is the key to top trading and investing simply refers to the algorithm that tells you ‘how much’ with respect to any particular position in the market.

He added:

John was a little shell-shocked over what had happened in the market over the last three days — he’d lost 70% of his account value. He was shaken, but still convinced that he could make the money back! After all, he had been up almost 200% before the market withered him down, He still had $4,500 left in his account. What advice would you give John? Your advice should be, “get out of the market immediately. You don’t have enough money to trade speculatively.” However, the average person is usually trying to make a big killing in the market, thinking that he or she can turn a $5,000 to $10,000 account into a million dollars in less than a year. While this sort of feat is possible, the chances of ruin for anyone who attempts it is almost certain.

I have been helping clients with these very issues in my trading courses for over a decade.

William Eckhardt (see: “The Complete TurtleTrader“), in attempting to get people to see the flaws in some trading strategies, once offered:

A price chart is an attempt to model relevant aspects of price change. Price change is not linear displacement, whether vertical, horizontal or oblique. Nonetheless, price change can be represented as vertical displacement and time elapsed as horizontal displacement. Such a model, however, invariably supports relationships that does not correspond to anything in the original process. The angular inclination of a trend on a price chart is a visually striking feature of this representation. Such angles have no intrinsic meaning for the price series, but this is one of the many factors (along with our facility for pattern recognition and wishful thinking) that contributes to our interpreting more from price charts than rigorous testing reveals is there.

Let me break down some of what Eckhardt is driving at. For example, new traders always talk of charts. Charts, charts, charts. Rarely do they talk of price. Many new traders think they are trading the “chart” when in reality if they want to be a great trend follower they should trade “price”. Eckhardt, in his best academic jargon, was basically saying, “don’t look for patterns where there are none!” Meaning if you are looking for angles embedded in a price chart for some predictive value or if you are developing some other arcane analysis, stop. The three best indicators? Price, price and price!

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A young guy from the U.K. has been writing me this morning. He has been making a case for why Buffett is the best investor ever. I have said, “Sure up until his bailouts and sweetheart government daddies helped save him in the Fall of 2008. If not, he was toast.” The young guy responded:

As regards the bailout, to be frank, if there wasn’t a bailout last year, it wouldn’t have been just BRK that went down the tubes – it would have been the entire global economic system. The disintegration of the banking system = no more credit = extreme deflation. Dunn Capital Management and every other business wouldn’t have been able to get short-term credit to pay its employees and suppliers. Asset prices would have gone into the abyss. If you think that trend followers would have made money in such conditions, remember that (a.) the rule of law and the enforceability of legal claims on assets may well have broken down, leading to civil disorder (b.) markets may well have failed to function, (c.) there would be no access to assets held by prime brokers, because they’d have gone down with the banks (see LEH). Basically anyone without tinned food and a log cabin in Montana would have lost under such a situation. BRK with its oodles of cash and AAA credit rating would have been one of the last to fail. My point is that you have to disassociate the investor and his record from the company – if for some reason Dunn failed under such a scenario, it wouldn’t reflect on Dunn as an investor, because we are talking about an event that has nothing to do with his skill as an investor. So, yes, maybe Buffett did manipulate the system to his advantage, but would we all honestly rather he hadn’t? Personally, I think this argument is rather overdone – the Fed and Treasury knew what happened in 1929, and there is no way, Buffett or not, they were going to let all the banks fail. I believe it is possible to replicate Buffett’s strategy – or at least its core – as much as it is any trend follower – buy companies with high free cash flow, strong franchises, little debt, during market crises when the P/E comes down below 15 or 20.

Bollocks. 100% bollocks. This is how the college text books will be rewritten to continue to salute “value” investing. They tell us the system would have crashed, but all we know now for sure is that the likes of Buffett and GS were saved. That is not a worthy investment strategy to follow.

This is still one of my coolest purchases:

More.

I received an email today with the subject heading of:

The Greatest Trade Ever: The Behind-the-Scenes Story of How John Paulson Defied Wall Street and Made Financial History by George Zuckerman (it is a book)

The email said:

This guy made like $24B in two years. More than all the combined profits of all the trend followers in history. 100% based on the fundamentals. You’d gain even more credibility if you acknowledged that other strategies besides trend following make money.

This is quite possibly one of the most ignorant emails I have ever received. This emailer finds one guy who bet the ranch and won — a strategy that no one else has ever replicated — and that is proof positive of what? The great thing about trend following: There is NOT just one practitioner who made $24B. Don’t get me wrong I salute John Paulson and his brilliance to figure out this great trade as it is the stuff of legends, but trend followers are not about one trade. In looking into Paulson I found this note about his success at Portfolio.com:

Left unexamined is the uncomfortable moral dimension of Paulson’s achievement. If he saw all of this coming, was it right for him to keep his own counsel, quietly trading while the financial system melted down? Do traders who figure out a way to profit from our misery deserve our contempt or our admiration, however grudging?

Paulson deserves admiration. Period. If you hate Paulson’s success, you are a punk.

Mike Shell turned me on to an article in the WSJ today from John Jannarone that said in part:

“The bigger question for ETF investors is the black-box nature of a trend-following strategy. Trading decisions are made according to undisclosed rules that aren’t based on fundamental analysis. ETFs are being used to democratize investing. But as they are used to pursue strategies further from their index-tracking roots, the warier individual investors need to be.”

The above was penned by a Wall Street Reporter in November 2009. How much lazier can a reporter be? I have questions for John-o-fundamentalo: What does black box exactly mean? Once we define it maybe you can tell us why it is bad? And why do investors need to be wary about moving away from index benchmarks? Bottom line, this reporter was saying to himself something to the effect of:

“I am a reporter who knows only about fundamental analysis. Today, I was put in charge of writing an article on trend following which I really don’t know sh** about, but since I work for a media outlet that sells fundamental analysis every day for a living, I had to ridicule trend following. Tomorrow I get to wake up and write what I know best about: daily fundamental predictions made up out of thin air that no one ever follows up on.”

Thanks John, you make my job more fun.

Richard Dennis offered wisdom 20+ years ago:

“…you have to be a pure empiricist and realize that what you see – the price action of the market itself – is all you get. Abstractions like crop size, unemployment and inflation are mere metaphysics to the trader. They don’t help you predict prices, and they may not even explain past market action.”

Many of the trend followers today simply don’t open up to reporters with gems like this.

Now, that is a great way to make numbers come alive.

Shout out to Barry Ritholtz.

This question comes in from a Linkedin contact of mine:

Hi Michael, my name is [name]. I am the Founder, Managing Partner, and PM for [name]. First, thank you for posting your videos on YouTube. They have been a great reference point for me. I have a question regarding benchmarking absolute return strategies. We have been debating this topic to no end. Our optimization models use a modified Mean Variance Analysis. Modified since we have proprietary concepts to account for higher moments and other factors which are ultimately priced into our final portfolio weightings. The problem I am having is when running the optimization models, what is REALLY the appropriate benchmark to be using?…I have actually resorted to using an equal weighted index of the identical portfolio as a benchmark to determine the investors incentive of allocating via our approach over …simply investing in the managers directly. I know this is assumption may have numerous flaws, however as a quick and dirty approach, it seems to make some sense. I will also benchmark against a portfolio using a basic mean variance approach (i.e. w/out accounting for non-normal returns, etc.). Ultimately, it doesn’t make sense to me that many absolute return managers will benchmark their performance vs. the S&P or the Barclay CTA index (which i believe measures systematic trend followers only). If you could provide me with any suggestions or thoughts. I would be very appreciative. Respectfully, [name]

There will be many different angles here and no one size fits all. Shoot, debating the concept of a benchmark alone can be lengthy. I open the topic up.