Michael Covel

Roger Lowenstein, who wrote the must read book When Genius Failed: The Rise and Fall of Long-Term Capital Management, offers some recent insight:

“In limiting risk, people also limit the opportunity for gain. It is common, today, for investors to own six or eight mutual funds, each of which is likely to be invested in hundreds of stocks. This will, they hope, assure that no little bump, no little meltdown, overly upsets their portfolios. But since when was investing about avoiding the bumps? Anyone investing for the longer term can safely ignore them.”
The Way We Live Now See a Bubble?
Roger Lowenstein
June 5, 2005

Avoiding the bumps is exactly what trend followers do NOT do. They accept the bumps. Lowenstein continues:

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A simple, yet classic piece of writing. Take a read of Ed Seykota’s bet sizing article.

When you trade as a trend follower, losses are often paid for with gains. Meaning there will be periods of up and down volatility with no clear trend directions. When the trends “hit” (something you can’t predict), then the gains far out pace losses. Sunrise Capital offered the following commentary for March 2005:

“The Global Monetary Program declined 4.8% in March, as investor sentiment suddenly turned bullish regarding the U.S. dollar, resulting in sharp reversals in most currency markets and, to a lesser extent, metals. The ensuing losses from long positions in the euro, Swiss franc, Australian dollar and Japanese yen easily outpaced gains from long positions in Japanese government bonds and short positions in Eurodollars. The stock index and energy sectors posted modest losses as well…Long positions in crude oil had benefited early on from a perceived increase in global demand and a tightening of supply. On the 23rd, however, U.S. government data showed that crude inventories were, in fact, growing, and the market reversed sharply. Gains from long positions in metals also saw a turnabout led by gold, which reversed to the downside as the dollar gained strength after midmonth.”
Sunrise Capital

Of course their fundamental analysis is after the fact and plays no role in their real-time decision making process within their trend following model.

Peter Panholzer, a short term systematic trader, recently offered:

“We don’t always understand that risk isn’t always a money risk; there’s the risk of regret. Sometimes you regret you haven’t been in the market, sometimes that you got out too early or that you’ve taken a loss when it wasn’t necessary. It’s not only the money we worry about, it’s also our regret we worry about.”
Peter Panholzer

He continued:

“System trading is different from technical trading…In technical trading, you’re reading tea leaves - the indicators. Interpretation of technical indicators is often subjective and not programmable. But you can program a system.”
Peter Panholzer

Nassim Taleb was asked about common mistakes traders make. He responded to Derivatives Strategy with an answer useful for both beginner & expert:

“As a trader, my job is to understand biases and trade on them. There are all kinds of biases. The most common is the small sample bias. Let’s say you have 1 to 1000 odds you will come home every day with a dollar and once in a while you lose $1000. Many traders show very steady incomes but they could be fooling themselves because they don’t have a long enough period of time to chart their performance. Their Sharpe ratio will not be indicative. In option trading, there is a similar bias. Short premium option traders, typically those who sell out-of-the-money options, are more likely to make money on a daily basis and then blow up. Likewise the yield hogs, those traders who would take any risk for a few basis points. You can fool yourself with your Sharpe ratios, and you can fool all of the financial engineers, but you can’t fool an old Chicago trader who went bankrupt twice. Another bias is what I call the size bias. If you have twenty thousand traders in the market, sure enough you’ll have someone who’s been up every day for the past few years and will show you a beautiful P&L. If you put enough monkeys on typewriters, one of the monkeys will write the Iliad in ancient Greek. But would you bet any money that he’s going to write the Odyssey next? You know that because of the sheer size of the sample, you’re likely to find a lucky monkey once in a while. But the same applies to traders.”

The other day a reader asked me if trend following would beat his current strategy. He said he consistently makes +25% a month every month. Taleb’s comments are useful for this individual.

We can’t avoid risk. It doesn’t go away. Consider:

“Markets are an evolving ecology. New risks arise all the time.”
Andrew Lo
CFA Magazine

The key to ‘risk’ is to make sure you have a plan to deal with the ups and downs before you start taking those risky behaviors.

Risk: what exactly is it? Ponder wisdom:

“Since we live in a world without crystal balls that allow us to clearly see the future, prudent investing is all about the management of risk and expected returns. A problem that both investors and investment advisors face is defining what exactly is risk. As you will see, risk can be many different things And since risk can be many different things to different people, investors/advisors are faced with deciding which risks are the most important to manage…Another risk that should be carefully considered is that of the unexpected negative surprise. Unfortunately, one of the most common and severe mistakes made by investors/advisors is to treat both the highly unlikely as impossible and the highly likely as certain. Prudent investors know that history teaches us that just because something has not yet occurred, does not mean that it cannot, or will not, occur in the future. One has to look no further than to the events of September 11, 2001 for proof of this important point. The potential for negative surprises should be built into any investment plan. Forewarned is forearmed. There is yet another risk investors/advisors must deal with-maverick risk. As Robert Arnott points out, “practitioners ‘know’ that the greatest peril is the risk of being wrong and alone. As such, we fall prey to the Keynesian dictum that it is more acceptable to fail conventionally than to succeed unconventionally. Decisions that leave an investor alone carry the inherent risk of being both wrong and alone. If an investor is wrong and alone, a strong likelihood is that the assets’ owner will not have the patience to see the investment decision through. The decision, even if correct in the long run, will be reversed before it can succeed.” We are all familiar with the expression “misery loves company.” Experiencing relatively low (but still positive) investment results may create more psychological risks to the investment plan being abandoned than experiencing losses if everyone around is having a similar experience.”
Paul Petillo

Charlie Wright of Fall River Capital paints a true picture of risk management:

“I often tell the story of the great fish restaurant that opened up just down the street from my office. It opened with great fanfare and was ranked in the top five restaurants in the city. The food was outstanding. But it only took a little more than a year and this great restaurant was out of business. Why? Because the key to running a good restaurant is not the food–it is cash management and risk control. It is making sure your business is run efficiently, keeping your costs (risk) in control, and managing your staff effectively. If you believe that the taste of the food is what makes a great restaurant, think of how great the food is at your favorite fast food restaurant. But, someday, watch how well that restaurant is run. Just as in the restaurant business, the key to profits in trading is not in the prediction or the indicator, but how well the trading strategy is designed and executed. The ability to achieve risk control and cash management will make the difference between a successful trader and an unsuccessful trader. If you ever have the opportunity to watch a successful trader, you will see that they don’t worry about where the market is going or about predicting when the next big move will take place. They aren’t looking to tweak their indicator. They are worried about their risk on each trade. Is the trade being executed correctly? How much of their total account is at risk? Are the stops in the right place? And so on.”
Charlie Wright
Chairman of Fall River Capital, LLC

Charlie reminds us all that great decison-making is needed for running a trading firm or running a restaurant.

I had conversations with two groups today. One group runs a fund that combines many traders together into a portfolio that aims for good returns, but less drawdown. The other group works with a trend following legend who shoots for absolute returns. Is there a right direction? Should you as a trader (or investor with traders) have multiple trading approaches combined or one great absolute return strategy? It is an interesting (and useful) debate. There will always be fierce arguments from each side for their point of view, but the choice ultimately comes down to what you want in your life and your performance.

It seems everyone wants the results, but not the risk. However, we all know it doesn’t really work that way (even if we refuse to admit it). David Harding, Managing Director of Winton Capital Management, put it in perspective in a January 2004 interview:

“…hedge fund management in general, is not a traditional asset management business