Is the trend really your friend?
The first piece of advice usually given to an aspiring trader is the well-worn phrase ‘the trend is your friend’. Trend-following traders identify one-way patterns and attempt to ride them for as long as possible. According to most seasoned veteran traders countertrend trading is irrational and regarded as a novice trader’s practice.
One of the fiercest advocates of the countertrend strategy is the well-known trader Nicholas Nassim Taleb, who coined the term ‘Black Swan’ and introduced probabilistic thinking to the financial markets. The objective of the countertrend approach in a nutshell is to experience a large number of trades with relatively small losses in order to catch a change in the existing trend, based mainly on the idea that if a market moves against the expected direction, it could move significantly.
Most academic theories of modern finance assume symmetry in market returns and are based on the idea that investors are rational and markets are efficient. However, investors may be perfectly rational when they examine charts and develop strategies at the weekend, but once they enter a trade things are quite different.
Risk measurement based on academic theory defines risk as volatility, regardless of direction, and uses annualised standard deviation of historical returns. Standard deviation assumes that market returns conform to a normal bell-shaped distribution. Symmetry-focused investors plot risk and return profiles in Gaussian normal distribution histograms, but market returns don’t fall into a symmetrical distribution and asymmetric return distributions can show asymmetry in both gains and losses. This type of investor may get excited after larger than usual gains, but it takes only a 50% decline to wipe out a 100% gain and a 50% loss requires 100% just to break even.
Probability v. expectation
What makes a distribution asymmetric is the fact that the probabilities of each event and the magnitude of each outcome are not equal. Let’s examine the mathematics behind that idea by means of a gambling example. We employ a strategy that has a 99.9% chances of making £1 (event A) and 0.1% chance of losing £10,000 (event B). The probability of gain or loss in itself is meaningless, unless it is examined in connection with the magnitude of the outcome.
In this case my expectation is a loss of almost £9 and, although the odds greatly favour event A, it is not such a good idea after all. The same mathematics applies to the financial markets as well. It is not solely about how likely an event is, but rather how much is made when the event actually happens. It seems that investors tend to get euphoric when they get it right, but what counts at the end of the day is not how many times you were right or wrong, but how much profit you made overall. (See Nassim Nicholas Taleb, Fooled by Randomness, 2004:99)
Psychology v. statistics
Psychologists have found evidence that people tend to get primarily affected by the occurrence or non-occurrence of a given event rather than its magnitude, i.e. a loss is firstly perceived as a loss and only later are the real implications considered. The same applies to profits.
Also according to psychologists, an unpleasurable moment, such as the acceptance of a loss, takes two pleasurable moments, such as the realisation of a profit, to balance out. Therefore a typical trader would inherently tend to focus on minimising their number of losses instead of optimising their total performance.
Markets have always been marked by rare and unpredictable events and the question you should ask yourself is whether these events are fairly valued.
Published: 19 September 2012
You should under no circumstances consider the information and comments provided as an offer or solicitation to invest. This is not investment advice. The information provided is believed to be accurate at the date the information is produced.