Tuesday, August 07, 2012

John Maynard Keynes and market irrationality

The well known economist (and trader) John Maynard Keynes once wrote "the market can stay irrational far longer than you can stay solvent". This was actually during 1920 when he suffered losses while trading currencies, and received the dreaded margin call from his brokers.

He had traded his economic beliefs, but did not pay sufficient attention to the uptrend occuring in the German Deutschmark (in which he held a short position).

Trend followers needn't worry about any of this, as they only trade in the direction in which the market is travelling. They are simply follow the trend, until such point in time that the trend reverses.

It is also clear from extremes in the market during periods of euphoria and panic that simply sitting and riding the trend, rather than trying to pick tops and bottoms in a market, is a far more profitable method of making money. One can think of the 1929, 1987 and 2008 market crashes, the 1980 gold bubble, the dot.com boom (and subsequent bust), and even back as far as Tulip Mania and the South Sea Bubble and see that following the trend until getting a reversal or exit signal would have allowed you to make large amounts of money, AND let you bank the vast majority of those profits (providing you follow the exit signal).

Currently the markets are in a somewhat choppy uptrend, despite the negative economic news coming out on a regular basis - some people may think that this is totally irrational. Now a trend follower may think that the markets are due for a sharp fall as well, but they will only go short when they receive the appropriate signal. Until that point in time, the trend is up, and therefore they will be long the markets. That could be tomorrow, it could be six months from now - who knows?

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