Trend following has the potential to be successful

trend followingWhy do you think trend following has the potential to be successful?

I would offer a few reasons, all based on human nature. The first is that we’re not very good as a species at reasoning about probabilities. We are good at other things, such as estimating speed and distance. Take the ability to catch a baseball, for example; physicists tell us this requires integrating differential equations, which is of course quite complex. By comparison, we make mistakes in easy probability problems.

One consequence is that we tend to have  only two responses to extremely small probabilities, neither of which is helpful: we ignore them completely or we exaggerate them. I would give the Anthrax scare some years back as an example of the latter. The probability that any single person would be infected with Anthrax was incredibly small, yet a lot of people were in hysterics.

The more typical response is to ignore very small probabilities altogether—to assume that  they’re essentially zero. Let’s say there’s a one percent probability that beans were going up a dollar. That should make beans go up a penny. In fact, what would typically happen is that  market participants would ignore that small probability, and the price wouldn’t respond at all. Let’s say the probability slowly creeps higher. At some point it registers on people’s mental scopes, so to speak. Then they tend to respond discontinuously to this continuous  development.

Another example of how people behave unreasonably when faced with probabilities is the way they respond to lotteries. If you offer subjects a sure win and you offer them a lottery that’s a little better, they’ll take the sure win. On the other hand, if you offer them a sure loss or a lottery that’s a little worse but has a chance of recouping, they’ll take the lottery.  Traders tend to follow the same—they take profits and they play with losses. This bias generates trends.

The trendiness of prices seems to be grounded in human nature.

Published in APM Interview with William Eckhardt

Igor Marinkovic

Electronic engineer, futures trader and property investor and total beginner in making good web sites

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