Trend following strategy approaches day-to-day trading decisions in a way most would not recognize: K.I.S.S. For example, each day millions of fundamental traders around the world attempt to evaluate a relentless onslaught of confusing, contradictory, and overwhelming market information, all to hopefully make profitable trading guesses for that day (e.g., the type of information on daily finance news).

Any individual decisions can be badly thought through, and yet be successful, or exceedingly well thought through, but be unsuccessful, because the recognized possibility of failure in fact occurs. But over time, more thoughtful decision making will lead to better overall results.

Robert Rubin³

Although they know decisions should be educated and, based on factual data, they see impulsive action as sound decision making, leaving them with absolutely no clue. They either end up paralyzed and make no decision, let someone else decide or guess. It’s a vicious and repeating cycle of decision-making frustration.

Terrence Odean, a professor at the University of California, Berkeley, uses a roulette wheel to illustrate. He postulates that even if you knew the results for the last 10,000 roulette spins, knew what materials the roulette wheel is made of, and whatever hundred other pieces of information you could dream up as possibly being useful, you still will not know what matters: where the ball will land next.⁴

Ed Seykota takes Odean’s thought a step further in critiquing decision making: “While fundamental analysis may help you understand how things work, it does not tell you when, or how much. Also, by the time a fundamental case presents, the move may already be over. Just around the recent high in the Live Cattle market, the fundamental reasons included Chinese Buying, Mad Cow Disease, and The Atkins’ Diet.”⁵

Trend followers excel because they control what they know they can control. They know they can choose a level of risk. They know they can estimate volatility. They know the transaction costs. However, there is still plenty they know they do not know, but in the face of that uncertainty they still step up to the plate and swing. That ability to make a decision is core to trend trading philosophy—that is, swinging the bat without fear. Those decision-making skills might not appear worthy of endless discussion, but the philosophical framework of that decision making is critical to execution.

People who make decisions for a living are coming to realize that in complex or chaotic situations—a battlefield, a trading floor, or today’s brutally competitive business environment—intuition usually beats rational analysis. And as science looks closer, it is coming to see that intuition is not a gift but a skill.⁶

If we were to keep the trend following style in baseball terms, the question would be: “Do you want to play ball or not?” When the pitch comes—if it’s your pitch, swing the bat. There is no time to wait for more information before you swing. In an uncertain world, if you wait until the data is clear, the ball has crossed the plate, you miss the pitch. You are out.

Occam’s Razor

Nature operates in the shortest way possible.

Aristotle

Tackling the challenge of making smart decisions in a complicated market world is hardly new. As far back as the fourteenth century, when medieval life was as rigidly complex as its cathedrals, philosophers grappled with how to make simple decisions when pressed for time. In any scientific realm, especially when a new set of data requires the creation of a new theory, many hypotheses are proposed, studied, and rejected. And even when all unfit hypotheses are thrown out, several might remain. In some cases they reach the same end, but have different underlying assumptions. To choose among similar theories, scientists (and trend traders) use Occam’s razor.

Occam’s razor is a principle attributed to logician and Franciscan friar William of Occam. The principle states entities must not be multiplied unnecessarily. In its original Latin form, Occam’s razor is Pluralitas non est ponenda sine neccesitate. This bit of Latin still underlies all scientific modeling and decision making. A common interpretation of the principle is the simplest of two or more competing theories is preferable.⁷ Occam’s razor does not guarantee the simplest solution will be correct, but it focuses priorities.

Heuristic: Serving to discover; using trial and error; teaching by enabling pupil to find things out.

Oxford Dictionary

Fast and Frugal Decision Making

In the field of cognitive science, economics, and trading, it has always been assumed the best decision makers have the time and ability to process vast amounts of information. Not true. The field of heuristics explores how to make constructive, positive choices by simplifying processes. Gerd Gigerenzer’s Simple Heuristics That Make Us Smart shows how to cope with complexities using the simplest of decision- making tools. His premise: “Fast and frugal heuristics employ a minimum of time, knowledge, and computation to make adaptive choices in real environments.”⁸

We could still imagine that there is a set of laws that determines events completely for some supernatural being who could observe the present state of the universe without disturbing it. However, such models of the universe are not of much interest to us mortals. It seems better to employ the principle known as Occam’s razor and cut out all the features of the theory which cannot be observed.

Stephen Hawking⁹

For example, a component of fast and frugal heuristics is one-reason decision making. This is what trend followers do when faced with a trading decision: “One reason decision makers use only a single piece of information for making a decision—this is their common building block. Therefore, they can also stop their search as soon as the first reason is found that allows a decision to be made.”¹⁰

Whether your decisions are about life in general or trading in particular, your decision-making process should not be complex for the sake of complexity. You make the trading decision, buy or sell, on a single piece of information of price. The great trend traders share character traits with other achievers across other fields such as quick reactions or being able to turn a position on a dime.¹¹

I’m increasingly impressed with the kind of innovation and knowledge that doesn’t come from preplanned effort, or from working towards a fixed goal, but from a kind of concentration on what one is doing. That seems very, very important to me. It’s the actual process, the functioning, the going ahead with it.

J. Kirk T. Varanedoe Museum of Modern Art New York City

When you are faced with a decision, going with the first instinct is almost always the right choice. If you reflect and consider options and alternatives or try to second-guess, you will end up making the wrong decision or the same right decision, but only after taking valuable time to get there.

Gigerenzer elaborates: “Fast and frugal heuristics can guide behavior in challenging domains when the environment is changing rapidly (for example, in stock market investment), when the environment requires many decisions to be made in a successively dependent fashion. These particular features of social environments can be exploited by heuristics that make rapid decisions rather than gathering and processing information over a long period during which a fleeter-minded competitor could leap forward and gain an edge.”¹²

Consider how players catch—like in baseball. It may seem they would have to solve complex differential equations in their heads to predict the trajectory of the ball. In fact, baseball players use a simple heuristic. When a ball comes in high, the player fixates on the ball and starts running. The heuristic is to adjust the running speed so the angle of gaze remains constant—that is, the angle between the eye and the ball. The player can ignore all the information necessary to compute the trajectory, such as the ball’s initial velocity, distance, and angle, and focus on one piece of information, the angle of gaze.¹³

Heart, guts, attitude and the ability to tolerate uncertainty are core to long-term winning.

Michael Covel

To be uncertain is to be uncomfortable, but to be certain is to be ridiculous.

Proverb

Former baseball catcher Tim McCarver drew the same conclusion, and he is in no way a trained decision-making scientist:

Before each delivery, the catcher flashes a hand signal to the pitcher indicating the best pitch to throw. Imagine that a strong batter faces a count of three balls and two strikes, with runners on first and third. What should the hurler serve up, a fastball high and inside, a slider low and away, or a change-up over the heart of the plate? By the way, Mark McGwire’s up next. You have to put down a sign quickly. The first one is going to be the right one. For most baseball decisions you can train yourself to be right quicker than in five seconds.¹⁴

McCarver is talking about bare-bones decision making with incomplete information. “Be quick” is his central tenet. The transition from fast and frugal decision making by a baseball player, McCarver, to fast and frugal decision making by a baseball team owner and trader, John W. Henry, is remarkably smooth. Henry was one of the first to focus on the use of heuristics in trading.

Leaving the trees could have been our first mistake. Our minds are suited for solving problems related to our survival, rather than being optimized for investment decisions. We all make mistakes when we make decisions.

James Montier

At the New York Mercantile Exchange, the president of John W. Henry’s firm talked fast and frugal:

“We’re a trend follower; we use just price information and volatility in order to make decisions. The reason why we do that is because we don’t think that we can predict the future . . . [Further] I can’t be an expert in every one of them [markets]. In fact I can’t be an expert in any of them, so what I have to do is be able to be expert at being able to move faster when I see information that’s important . . . So my way in which I can move faster is to just use the price information that’s the aggregation of everyone’s expectation . . . What we try to do is extract the appropriate signals as quickly as possible so we can act fast to limit our risk and also create opportunities . . . we’re frugal in the senses that we use . . . very simple recognition heuristics . . . the price information itself . . . what could be an example of this? We like to think of those as non-linear models. But it’s no different than what some people describe as breakout systems.¹⁵

His simple heuristic for making trading decisions is price action. But there is more:

Most people believe that great chess players strategize by thinking far into the future, by thinking 10 or 15 moves ahead. That’s not true. Chess players look only as far into the future as they need to, and that usually means thinking just a few moves ahead. Thinking too far ahead is a waste of time: The information is uncertain. The situation is ambiguous. Chess is about controlling the situation at hand.¹⁶

“Finding a price trend among noisy random price moves presents a challenge similar to that of filtering information from the noise in many other applications, such as astronomy, audio, ballistics, image processing, and macroeconomics. For example, engineers who track ballistic missiles based on noisy radar information attempt to filter out noise to determine the missile’s direction. Similarly, macroeconomists and central bankers who receive imperfect economic data—such as estimates of GDP for countries and unemployment rates collected from many sources (with errors)—try to assess whether an economy is heading into a recession or is overheating. Investors trading on trends in financial markets face the similar challenge of assessing the direction prices are headed by filtering noisy price data. In the world of audio, Ray Dolby developed the Dolby system to reduce noise in music recordings and enhance the signal that the listener hears. Along the same lines, trend followers use quantitative tools to enhance the signal of the price trend and reduce the noise around it.¹⁷

The use of quantitative tools does not mean complicated analysis. The fewer trading decisions traders make—the better. This may seem counter-intuitive, but in a complex world where decisions have to be made with limited information and real-world time constraints, time to consider all possible alternatives is not an option.¹⁸

Trend following is inherently simple, but very few want to believe—especially many respected market players—that something simple can make money consistently. The reason trend followers do well is because they stay focused and very disciplined. They execute their game plan—that is their real strength.¹⁹

Not everyone agrees with the science of fast and frugal heuristics. One group said, “This can’t be true, it’s all wrong, or it could never be replicated.” Among them were financial advisors, who certainly didn’t like the results. Another group said, “This is no surprise. I knew it all along. The stock market’s all rumor, recognition, and psychology.”²⁰

The 2016 study “The Enduring Effect of Time-Series Momentum on Stock Returns over Nearly 100 Years” provide[s] evidence that supports the view that time-series momentum (also referred to as trend following) is one of the few investment factors that meet five important criteria for inclusion in a portfolio; specifically, it is persistent, pervasive, robust, investable and intuitive. Their study covered the 88-year period from 1927 to 2014.²¹

Qui court deux lievres a la fois, n’en prend aucun.

However, staying exclusively with the simple heuristic of price is tricky. Traders can’t help trying to improve. They become impatient or even bored with systems. Far too many like to make decisions even if those decisions are short-term emotional fixes that have zero to do with making a profit.

For example, let’s say you have a buy signal for Google. You must buy the stock if it follows rules. You must trust the rules and your decision making to follow the rules. Don’t make it more complicated than it is—buy when you get the signal. That’s not to say that trend following in its entirety is elementary. However, the decisions that go along with it should be processes you can jot out on the back of a napkin.

Innovator’s Dilemma

Clayton M. Christensen, author of The Innovator’s Dilemma, understands trend following, even if not by the name I use. What Christensen understands are odds and reactions. He saw this as readers attempted to decipher his work:

“They were looking at Innovator’s Dilemma for answers rather than for understanding. They were saying, ‘tell me what to do’ as opposed to ‘help me understand so I can decide what to do.’ . . . Wall Street analysts are theory-free investors. All they can do is react to the numbers. But the numbers they react to are measures of past performance, not future performance. That’s why they go in big herds. Wall Street professionals and business consultants have enshrined as a virtue the notion you should be [fundamental] data-driven. That is the root of companies’ inability to take action in a timely way.”²²

“Many are looking for highly complex ways of interacting with the markets, when most of the time it’s only the simple ones that are going to work.”²³

Charles Faulkner

Christensen drives home again that you must make decisions without all the facts. You cannot foresee how a changing market will look until change has taken place, and then it’s too late. Take, for example, an up and down stock such as Yahoo!. You probably said, “I should have bought here and sold there.” But there was no way you could have predicted the future of Yahoo!. You could only act early before the direction of the trend was obvious. You must be in ready, set, go mode, long before pundits say the coast is clear. They are the herders Christensen slams—those in the sheep business.

Consider another decision-making story similar to Tim McCarver’s baseball example. Years ago, the catcher and the pitcher called pitches. Today you still have a catcher and a pitcher, but the coaches are usually calling the pitches. Why? So the pitcher can execute exactly what he’s told to do. When the typical Major League pitcher gets a signal to throw a curveball, he doesn’t stand out there on the mound debating it. He says to himself, “This is the system we’re using. I have a coach on the sidelines with a computer. He’s studied and charted everything. He knows I should throw a curve ball. The only thing I’m going to worry about right now is throwing the curveball to the precise location that I’m supposed to throw it.” The pitcher then can concentrate solely on execution—the best pitch possible he can throw right now.

Everything should be made as simple as possible, but not simpler.

Albert Einstein

Likewise, as a trend follower, you wake up and see the market move enough to cause you to take action, like a buy signal. For example, let’s say the rule dictates buy at price level 20. You do it. You don’t debate or second-guess it. Sure, that might feel boring and it might feel like you’re not in control. It might feel like there should be something more exciting, more adrenaline-fueled, more fun for you to do, in which case consider a trip to the Spearmint Rhino in Vegas. If you want to win, however, you execute the signal as prescribed. That means you trade at price level 20 and throw the curve ball when called for by the coach. Fun, excitement, and glamour are not what you want. Executing correctly to win is what you want.

The Greek philosopher Archilochus tells us, the fox knows many things, but the hedgehog knows one great thing. The fox—artful, sly and astute—represents the financial institution that knows many things about complex markets and sophisticated marketing. The hedgehog—whose sharp spines give it almost impregnable armor when it curls into a ball—is the financial institution that knows only one great thing: long-term investment success is based on simplicity.

John C. Bogle

Process versus Outcome versus Gut

The decision-making process is that—a process. You can’t make decisions based on what you want the outcome to be. Michael Mauboussin has long presented a compelling argument for process:

In too many cases, investors dwell solely on outcomes without appropriate consideration of process. The focus on results is to some degree understandable. Results—the bottom line—are what ultimately matter. And results are typically easier to assess and more objective than evaluating processes. But investors often make the critical mistake of assuming that good outcomes are the result of a good process and that bad outcomes imply a bad process. In contrast, the best long-term performers in any probabilistic field—such as investing, sports team management, and pari-mutuel betting—all emphasize process over outcome.²⁴

When the mind is exhausted of images, it invents its own.

Gary Snyder

Building on that wisdom, Edward Russo and Paul Schoemaker, professors in the field of decision making at Wharton, present a simple tool (see Figure 7.1) to map out the process versus outcome matrix:

The process versus outcome schematic shown in Figure 7.1 is built into trend trading systems. For example, imagine the process you use to make a decision is sound. If your outcome happens to be good, you can view your result as deserved. On the other hand, if you use a good process and your outcome turns out bad, you take solace with failure as a bad break, but you achieved it with a good process.

Trend trader Larry Hite put it another way: “There are four kinds of bets. There are good bets, bad bets, bets that you win, and bets that you lose. Winning a bad bet can be the most dangerous outcome of all, because a success of that kind can encourage you to take more bad bets in the future, when the odds will be running against you. You can also lose a good bet, no matter how sound the underlying proposition, but if you keep placing good bets, over time, the law of averages will be working for you.”

Always do whatever’s next.

George Carlin

That’s sage advice from one of my favorite thinkers, but the romance of in-the-moment-no-process-gut decision making remains a strong pull in for modern world. From admiration of entrepreneurs and firefighters, to the popularity of books by Malcolm Gladwell and Gary Klein, to the outcomes of the last two U.S. presidential elections, instinct over process is positioned as ascendant. Many push intuition as the X factor separating men from the boys. Gut decisions, they say, are needed in moments of crisis when they say there is no time to weigh arguments or calculate the probability of every outcome. Gut decisions are made in situations, they say, where there is no precedent and consequently little evidence.²⁶

There is a place for gut decision making in life choices, but it’s not applicable to the markets. If you have no market process, and focus on profit outcomes alone, it will end badly. Guaranteed.

Confine yourself to the present.

Marcus Aurelius

Summary Food for Thought

• Ed Seykota: “One pretty good [heuristic] is: ‘Trade with the Trend.’”
• Occam’s razor dictates if two equal solutions, pick the simplest.
• Fearless decision makers have a plan and execute. They don’t look back. If something changes, they adjust.
• Murray N. Rothbard: “If a formerly good entrepreneur should suddenly make a bad mistake, he will suffer losses proportionately; if a formerly poor entrepreneur makes a good forecast, he will make proportionate gains. The market is no respecter of past laurels, however large. Capital does not ‘beget’ profit. Only wise entrepreneurial decisions do that.”
• Tom Asacker: “The process, not the proceeds.”