Elnora H. and William B. Quarton Professor of Business Administration and Economics, Coe College, Iowa
I Completed My Edcuation, 10/29/2022
The story of Jesse Livermore in the “Reminiscences of a Stock Operator” lures many people to trade stocks as trend followers. There are many well-known traders who hail the book as the bible. I used to consider myself a trend follower. I used trend analysis to determine the timing of trades. But I gradually realize that there might be giant pitfalls following trends.
Richard Dennis, the most famous CTA trend follower and the creator of turtle traders, failed to have any meaningful comeback after his blowup in the 1980s. Of his turtle disciples, Jerry Parker seems to be the only one doing well, but I don’t understand why his fund went from over $1.5B AUM to less than $100M. Another Livermore worshiper, Colm O’Shear, who was featured nicely in Jack Schwager’s Hedge Fund Market Wizards, closed his fund in 2016.
There are more failed trend followers. Why did William O’Neil create the Investor Business Daily and write the book “How to Make Money in Stocks”? Did he try to get rich by selling pickaxes instead of mining gold?
My analysis of why so many trend followers eventually fail is that trend signals have many false positives. To be a great trend follower, you need to manage the risk well. You need to behave like a robot, no emotions attached to your trading. Your goal is always to catch just one nice ride, while avoiding losses to pile on. But having a good risk management system means you have to have steel-like discipline. You should never be swayed by the market condition or your own psychology.
Livermore himself suffered from his losing control over the cotton trade. When emotions and psychology of minds take over, you always find yourself breaking rules you set for yourself. And when losses become unbearable, you always hope for a quick comeback by breaking another rule. This is why Dennis never recovered. He lost his mental control.
There are two true solutions to this eventual downfall. First is to build a wall around yourself. I think this is why Ed Seykota became like a monk, living by Lake Tahoe and having no connections with the market. It is impossibly hard to trade like a monk, because most people are lured to the market for the excitement. Truly successful trend followers actually want to live in solitude. Nicolas Darvas, the man who was famous for his box system, was the most successful when he was traveling overseas, cut off from communications with Wall Street. When Darvas was in New York, he lost everything. He only recovered after he created a schedule that had no overlaps with Wall Street’s trading hours. I don’t think I can do that.
The second solution is to act like Jimmy Lai. Lai is the legendary Hong Kong prisoner of the Chinese Communist Party. He got his startup capital by betting against the Hang Seng back in 1975, after reading the Reminiscences. After he earned his money from the market, he went to the Guan Yu Temple to swear on his pinkies: if he ever “gambled” again in the stock market, he would chop off his pinkies. What kind of solution is that, you may ask? If you can’t control your emotions, stay away from the arena.
The bottomline is that you really can’t get rich by being a trend follower forever. As most great investors have done in their lives, I must evolve. Buffett went from a Ben Graham-like investor to a Phil Fisher-styled guru. I’d like to think my education has told me that I must rely less on trend following.
All roads lead to Rome. Rome is to believe that stocks have only one true long-term driver: business growth. Becoming a Fisher, Buffett, Lynch, and Munger-type investor has one unbelievable benefit, which I just realized recently: you have the peace of mind, regardless of what is really happening out there. You don’t have to be like a monk. You can sit back and relax to watch great executives working for you. And count your money! This realization is probably the best thing that has happened to me in 2022.
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