Thursday, December 04, 2014

Risks and rewards

There are plenty of people out there who are attracted towards a particular method of trading or investing, and who believe they can ride out periods of non-performance or a drawdown, in order to achieve the longer-term returns that are possible.

This is particularly true of trend following. There are countless examples of trend followers who have significantly outperformed all benchmarks over the long haul, yet in order to achieve this they have had to endure periods where things haven’t gone their way.

Trend follower Bill Dunn is a case in point – his fund suffered a drawdown of 40% over a twelve month period in 1999/2000. That was fully recovered in the next quarter. In late 1981 they had lost 42% over the preceding year. The very next month, they made 18%, and over the next 3 years they made more than 400%!

As a result of this, it is quite possible for a trend follower to suffer say 10 months in every year with little in the way of profits. Then, in the other two months, you can suddenly capture a major trend or two and easily end well up for the year. That is the nature of the beast.

Dunn was able to a ride out these periods as he had complete faith in the robustness of his approach. Remember, trend following in its purest form is an absolute returns approach. The downside is limited as far as possible, yet the potential upside is not limited in anyway. This is why, when major trends start to take hold, they can go through explosions of significant out-performance. Equally though, the drawdowns can be larger than most people can stomach.

In other words, Dunn wanted the big rewards, and was prepared to embrace the risk involved to achieve those rewards, along with going through the inevitable drawdowns. However, not everyone can deal with those fluctuations.

Plenty of traders, or people who invest their money with a trend following fund manager, may say that they are prepared to tolerate a drawdown of say 20% over a period of time. Yet when reality hits, and they are confronted with such a scenario,  they are all too quick to bail out, or to ditch the trend following approach. Often, this is right at the time when the performance has bottomed out.

In my own case, I am viewing my recent poor performance as a temporary blip. It's only a very small sample out of the next 10,000 trades. Having been through the cycle of market uptrends and downtrends, periods of good performance and not-so good performance, I am prepared to accept such periods as I know things will start to click again. Like Bill Dunn's performance, it is quite possible that the losses incurred will be fully recovered in quick time. Trend following returns follow trends themselves as the markets traded move from a non-trending state to a trending state, and vice versa. This therefore fills me with anticipation going forward.

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