As you read Gladwell’s PDF…keep in mind trend followers prepare every day for those “totally unexpected events”. That’s how they make money.
Trend following strategies are about “fat tails”. What does that mean? Patrick L. Welton, of Welton Investment Corporation explains:
No, there is no evidence or logical way to support this. Starting from first principles, we know the source of return to trend-following techniques results from sustained market price movements. Examination of recent and past data demonstrates empirically similar sustained price movements. Statistical examination of the distribution of prices also is similar over large enough data samples in that the kurtosis, or fat tails, is also similarly present. From a fundamental perspective, we could summarize the majority of return opportunities falling into several categories: macro-economic changes such as interest rates, asset values, inflation rates, and relative currency valuations taking place over months to years; physical supply and demand imbalances such as for commodities including seasonal stress factors taking place over weeks to months; and short-term market phenomenon such as liquidity contractions generally lasting from weeks to months. The common thread woven throughout these is the sustained change of price resulting from future unknowable events. Human reaction to such events, and the stream of information describing them, takes time and runs its course unpredictably. The resulting magnitude and rate of change of price is not reliably foreseeable [which is why trend following works].
More on fat tails and outliers.
What Fat Tails Mean for Trend Following
Standard financial models assume price changes follow a normal distribution, the familiar bell curve where extreme events are rare and their magnitude is predictable. In a normal distribution, a move of five or ten standard deviations is essentially impossible. In actual markets, such moves happen with regularity. These are the fat tails: events that occur far more often than the normal distribution predicts, and when they occur, they are far larger than the model expects.
Trend following is structurally positioned to profit from fat tail events. The strategy holds losing positions for small, defined losses and holds winning positions for as long as the trend continues. When a fat tail event produces a large sustained price movement, the trend follower is already positioned in the direction of that movement and holds through it. The event that destroys a portfolio built on the assumption of normal distribution is the same event that produces the trend following manager’s largest annual return.
Welton’s description of the three categories of opportunity, macro-economic changes, supply and demand imbalances, and short-term liquidity contractions, covers the full range of events that produce the large price movements trend following captures. None of them are predictable in advance. All of them produce sustained price movements that a reactive system following price can capture. The unknowability of the events is not the obstacle. It is the precondition for the opportunity. A world where all macro-economic changes were foreseeable would be a world where those changes were already priced in and no trend would develop from them.
Gladwell’s article frames the contrast between Nassim Taleb, who prepared every day for the unexpected catastrophic event, and Victor Niederhoffer, who built a strategy that collected steady premiums until a single unexpected event wiped out everything. The trend follower occupies a different position from both: not betting on catastrophe arriving, not betting against it, but following wherever price leads when it does arrive. The preparation is in the rules, not in the prediction.
Frequently Asked Questions
What are fat tails in financial markets?
Fat tails refer to the statistical reality that extreme price movements occur far more frequently in financial markets than standard normal distribution models predict. A five-standard-deviation move that normal distribution theory says should occur once in millions of years happens in markets every few years. Portfolios built on normal distribution assumptions are systematically underprepared for these events.
Why does trend following benefit from fat tail events?
Because fat tail events produce large sustained price movements, and trend following is designed to capture large sustained price movements. The same event that destroys a convergent strategy collecting steady premiums is the event that produces a trend following manager’s largest annual return. The strategy does not predict the fat tail. It is positioned to follow price wherever it goes when the fat tail arrives.
What is the common thread in Welton’s three categories of trend following opportunity?
Sustained price change resulting from future unknowable events. Whether the driver is a macro-economic shift, a supply and demand imbalance, or a liquidity contraction, the common feature is that human reaction to the event and the information describing it takes time to play out. That time produces the sustained price movement that trend following captures. The unknowability of the event is not the problem. It is the source of the opportunity.
Trend Following Systems
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