Feeling good…isn’t good

Long-term listeners of our Systematic Investor podcast series know that we have often praised Trend Following as a strategy that is “easy”.

What we mean by this term is that Trend Following is fairly easy to understand as an investment concept. It is rules-based and doesn’t allow any room for discretionary decisions. It tends to open long positions at new highs and short positions at new lows, counting on the markets’ tendency to form long-term trends. Trend Following can have various configurations but in its simplest form, it can be executed with “one entry and one exit”- a rule that makes the strategy simpler and easier to understand than pretty much anything out there.
It is important to stress, however, that “easy to understand” doesn’t mean “easy to implement”. Precisely because implementing a Trend Following system is so challenging, very few people attempt to do it, and out of those who do, many fail.

We have spent countless hours on the Systematic Investors podcast series discussing the operational challenges of setting up a robust, dependable and profitable Trend Following system. We have discussed it all – from collecting and using market data, through designing your trading rules, all the way to risk management, dealing with inflows and outflows, position sizing, and anything else you can think of. It is all in the back catalog, which – as usual – we highly encourage you to listen to.

In this week’s episode Jerry Parker – the legendary Turtle and a regular guest at the podcast – focused and emphasized another aspect of Trend Following that makes it so difficult to implement – the mental game.

You see, many traders approach Trend Following with the wrong mindset. They design a system, run a backtest, witness a strong long-term performance and then launch it. What so many fail to appreciate is the pressure and doubt that inevitably creep into their minds when their portfolio sits on a large drawdown. And because these emotions are so human and so strong, many traders start meddling with their systems. Some abandon their system altogether which - as we all know – is pretty much the worst course of action they can take. Others, who are more emotionally resilient, stick with their system but design an elaborate a set of rules aimed at decreasing the level of drawdowns – all in the name of making them feel better.

The problem with this approach is that “if it feels good, it usually isn’t good”, as Jerry put it in the latest episode. Rules that aim at reducing the drawdown and diminishing the natural volatility of a Trend Following system come at the price of lower absolute returns. This is the reason why real successful trend following traders don’t bother with attempting to reduce the drawdowns of their systems. They simply accept the fact that this is the cost of doing business and harnessing the attractive long-term returns that Trend Following has to offer.

Curious to find out what else Jerry said on this and many other topics? Feel free to tune into this week’s episode of our Systematic Investor podcast series and find out yourself. As usual, we promise your time will be well spent.