Pod Insights Michael Covel's Trend Following Ep. 1328: Trend Following Masters with Michael Covel on Trend Following Radio About this episode Please enjoy my monologue Trend Following Masters with Michael Covel on Trend Following Radio. This episode may also include great outside guests from my archive. --- I’m MICHAEL COVEL, the host of TREND FOLLOWING RADIO, and I’m proud to have delivered 10+ million podcast listens since 2012. Investments, economics, psychology, politics, decision-making, human behavior, entrepreneurship and trend following are all passionately explored and debated on my show. To start? I’d like to give you a great piece of advice you can use in your life and trading journey… cut your losses! You will find much more about that philosophy here: https://www.trendfollowing.com/trend/ You can watch a free video here: https://www.trendfollowing.com/video/ Can’t get enough of this episode? You can choose from my thousand plus episodes here: https://www.trendfollowing.com/podcast My social media platforms: Twitter: @covel Facebook: @trendfollowing LinkedIn: @covel Instagram: @mikecovel Hope you enjoy my never-ending podcast conversation!
Transcript 0:00 Speaker 00 Today I want to share with you a chapter from my book Trend Following Masters, Volume One.
0:08 Speaker 00 No big setup. Enjoy the insights. And just imagine how crazy this world is that this story exists.
0:20 Speaker 00 What an amazing time to learn how things really happen, how things really unfold. It's always a surprise. It's never predicted. Enjoy.
0:46 Speaker 01 Chapter One, Bill Dreis, Surfing the Waves.
0:51 Speaker 01 Bill Dreis graduated from MIT with a degree in Electrical Engineering. He then went on to Harvard Business School where he was attracted to Bayesian Decision Theory and Operations Research. After graduating, he went to work for a think tank in California that was doing computer modeling of strategic and tactical warfare. And that introduced him to state-of-the-art modeling. Bill says of his time at the think tank, "We were working under Air Force contracts, and we were exploring different kinds of tactics and missile firing strategies, or ground wars in Europe and that sort of thing." Most of the work was done by young engineers with mathematical backgrounds.
1:34 Speaker 01 Michael Note. "I knew the name Bill Dreis from the Performance Tracking Services, but I had never talked to him. Niels Kostrop Larson of Top Traders Unplugged connected me. This is how life works. It's all random. Be prepared because life is six degrees of separation. But in the trend-following world for me, it's one degree."
1:59 Speaker 01 Michael Covel. I want to jump in with a philosophical discussion about one of your heroes, if you'd refer to him that way, Benoit Mandelbrot. In 2008, he made a point about efficient market theory proponents. He said they'd like to take the events of 2008 and sweep them under the rug like they're an act of God and forget about them. I'm sure you connect with that. Why don't you tell us where Mandelbrot's going with that comment? Bill Dreis. What he's saying is that from a statistical point of view, the markets are not random walks. There's a bias in the markets, a persistence that leads mathematically to what we call fat tails. This is an intrinsic characteristic of the market.
2:43 Speaker 01 It's not an exception or something that's out of the ordinary. When I was working for Mandelbrot, I applied his idea of fractal dimension to different markets. I did an analysis of all the markets to see if they had, essentially, a fractal dimension that indicated that they were persistent. After analyzing all the markets and finding that to be true, to varying degrees, I formulated what I consider to be a scientific argument from Mandelbrot's conjecture. What he's saying is that the efficient market hype guys got it wrong when they were assuming that the markets were random.
3:22 Speaker 01 Part of the reason, in my opinion, was that these top economists were unable to beat the market themselves, so they decided that nobody else should beat it either, and so they came up with the idea that the markets were purely random. What's notable is that Mandelbrot's first paper on fractal geometry dealt with the futures market in cotton. There was a popular book called "The Random Nature of Stock Market Prices" that was published in 1974. Mandelbrot was the dissenting voice in relation to the random walk theory of the markets at that time. Even now, the random walk seems to be embedded in the academic view.
4:04 Speaker 01 It's long since been proven, not only by analysis but also by experience, that the random walk is not true, and the idea that the markets do in fact have fat tails is pretty much accepted, certainly among market participants.
4:19 Speaker 01 That's what provides the basis for trend following. It says that trends persist longer than would be expected if it were a random distribution. It's true that the particular methodology I use is based upon fractal geometry. But the persistence in the markets is what makes any reasonable trend following system operational. Michael. Let me focus on the word academic for a moment. If someone looks at your background, MIT, Harvard, they're going to see an academic pedigree, but you lean to the more practical side. In your early career, you worked in operations, research, defense contracting, and then you went off in another direction and killed it as an entrepreneur.
5:04 Speaker 01 But what were you thinking while you were trading? You're making a lot of money over many decades, yet the academic folks are getting all the publicity. The wrong message was spreading. I'm not suggesting you or other trend followers were entirely ignored, but your work was largely anonymous for a long time. What were your private thoughts as you watched these academics going down this one path? And here you are actually living it and seeing something entirely different? Bill. You mentioned my academic pedigree, but I stepped out of that, just in time. I went to work for a think tank in California when I graduated from business school. We were doing state-of-the-art modeling for structure analysis and missile targeting.
5:48 Speaker 01 This was at the height of the Cold War. A lot of the work involved looking at problems from first principles. Instead of taking existing tools, we redirected various techniques that led us into much more independent ways of thinking. One of my early discoveries was that there are a number of topics on which the scientific consensus is not supported. The point is, I think, that to some extent academics are overeducated, in that they learn models in physics, that they then try to apply to markets. But these models are not appropriate. Had they started at a more basic level in analyzing these things, they'd arrive at the same place as myself and other traders.
6:32 Speaker 01 Michael, the freedom to explore different paths is what gave you the advantage. Bill, that's exactly right. In fact, I've lived my life to maximize that freedom. I've had the opportunity to think about a lot of things independently of a structure, that is, in some ways, fairly restrictive. The pressures of publishing deadlines and other commitments means most academics have a day job that keeps them from spending a lot of time doing creative thinking. I've benefited from not being in that institutionalized environment. Talking to other CTAs, commodity trading advisors, I find there's a lot of similarity. I know of other CTAs who have been interested in physics and various other topics
7:16 Speaker 01 that had nothing to do with CTAs. They had original ideas on these topics that are not in the textbooks, but they are not crackery, because these are educated, intelligent people. There's another world out there that exists more or less independent of academia. Michael, before you devised your early trend-following systems, what would have been the first example that you read about or the first person you understood as pioneering trend-following? Would it have been Doncian? Bill, my boss at the think-tank was a retired Air Force Colonel who had come across Doncian, and he got me interested in his ideas.
7:58 Speaker 01 I had access to Air Force computers, and I also read Edwards and McGee, the Bible of technical analysis, and found it somewhat helpful. Although most of the patterns they used were informative, the only ones that counted for me were things like trend lines and support and resistance. I set out to design a system that automated that kind of technical trading. That was my first system. My second system, the one that started in 1991, was based upon a more sophisticated analysis of the data that came from Mandelbrot, but generally contained the same features as my original model in terms of trend lines and support and resistance.
8:39 Speaker 01 Michael, can I keep you on that early stage? I'm curious. I bring up Don Cian and you bring up Edwards and McGee, two different approaches. When you first understood what Don Cian was doing, did you go ahead and reverse engineer it and figure it all out for yourself? Bill. Well, no, I think Don Cian was moving average crossovers, if I remember correctly. It was pretty basic stuff. In the early days, simple systems worked well because nobody was using them. You're competing against discretionary traders who had all the impediments of that style of trading. Almost any system would beat the average discretionary trader. That changed over time as more and more people got into the business.
9:23 Speaker 01 But nevertheless, the business is pretty much the same as it was. It's a matter of designing a system and then sticking with it. Michael, let's talk more about those early-stage personal philosophies. In preparing to talk with you today, I started to think of isolation. In the sense that here you are, you're figuring out where you want to go. You've got a few pieces of information, a few data points from other people. You weren't necessarily in a collaborative team. You weren't calling up Bill Dunn, John W. Henry, and Ed Secoda. You were doing your own thing. Bill. That's right. They were doing their own thing too. We were all discovering the same phenomena.
10:07 Speaker 01 I know Ed Secoda and Marty Bergen made the same discovery, or should I say, they confirmed the discovery of Don Cian, that a system would generally beat discretionary traders, or most traders in terms of the market. This has been discussed extensively by Daniel Kahneman in his book Thinking: Fast and Slow, in which he talks about comparing clinicians against simple systems. The systems tend to do better, not because they're smarter, but because they're more reliable. They aren't subject to a lot of psychological and other biases that tend to work against the trading. We're born with certain psychological biases, and they're hard to overcome.
10:50 Speaker 01 Of course, as a systems trader, the hardest thing is to stick with your system. Because you're always looking at the markets and saying, "Oh gee, maybe it's going somewhere else," or whatever. The most important part, which is understood by all the traders you mentioned, and anybody who is successful at trend following, is to stick with your system regardless of what you think the markets are going to do. Michael, as a trend-following trader going back many decades, when you read "Thinking Fast and Slow" for the first time, wasn't there a side of you that said, "Well, me and some of my peers figured a little bit of this out a long time before it was popular?" Bill, that's exactly right.
11:33 Speaker 01 But by the same token, Daniel Kahneman was doing his work at about the same time that we were doing our work, though we were operating in different spheres. Maybe we didn't know about him and he didn't know about us, but it wasn't like we scooped Daniel Kahneman. We were applying the knowledge.
11:52 Speaker 01 We were applying his first algorithm to clinical practice back in the 70s. It's a matter of different people working in different fields. Michael, let me take you back to where I started this conversation, because I would love you to put on your professorial hat. Let's imagine you've got a room full of doctors, attorneys, young MBAs, all kinds of people, and they don't know about you. They would say, "Gosh, you did well in 2008." But in the movie "The Big Short," the one guy who did well did something different. He was in all kinds of markets that were moving. When they hear your track record for that particular year, a lot of people will think, "Oh, he did what the Big Short guy did," or, "He just shorted the S&P."
12:38 Speaker 01 They won't have this holistic view that it was all of these markets moving. How did that year unfold that enabled you to do so well? Bill. Well, there's no decision involved in that process. That was the business I was in. I didn't change my trading at all. I might say that this was a banner year for all CTAs who were trend followers. For the simple reason the markets trended strongly. Anybody who was a trend follower was going to capitalize on that. The difference between me and the guys in The Big Short is they actually dug into this stuff and figured out what was going on and had a specific plan to deal with it. Me, I was lucky.
13:21 Speaker 01 It was a market situation, which was amenable to the way that I trade. But I didn't do anything different. I didn't foresee the crash. It happened, and I was in the right place at the right time. Michael. Your strategy from the ground up was built to take what the markets give you. Bill. That's right. And that's again where persistence comes in. The markets exhibit persistence, and that's what allows me and other trend followers to make money. Michael. I know you're a fan of surfing. How long have you surfed? Bill. I caught the bug when I left college. One of the reasons I got into commodities was it was something I could do from wherever I wanted.
14:04 Speaker 01 Could live wherever I wanted and design my life around surfing. Over the last few years, I've tapered off a bit because of age. But for a long time, surfing defined my life, where I lived, and what I spent my time doing. Michael. That's an inspirational point to consider in this day and age where so many people don't design their lives. People talk about it on social media and share all these ideas now. And Tim Ferriss has written a book about what you described. But you were doing it a long time before. Did you have anybody in your life who was giving you these freedom ideas to go live that way? Or did you look at it and say, "Okay, this trading thing looks cool. I want to surf.
14:46 Speaker 01 So let's connect the dots here, and this is what I'm going to do." Bill. It evolved over time. It wasn't necessarily something that came to me all at once. What I remember is that I was working for a company and I thought, what about my boss? Do I want his job? Do I want to work sixty hours a week, eighty hours a week, or whatever? Make more money and buy a car, a big house? And then what about his boss? Do I want to be his boss? And then I said, no, I want to have leisure time. I want to retire when I'm young so that I'm physically and mentally able to do the things I want to do and worry about my old age when I get there.
15:29 Speaker 01 Michael, is there anything in the surfing mentality that you've connected to your trading or that you see philosophically in the act of surfing? Bill, there's a whole sociology behind surfing. It was sort of an out-bomb mentality. The idea of being free and being able to travel and being there for the surf. The surf is a jealous companion because when it comes up, you got to be there. It's not like skiing where there's snow in the mountains and you go to the mountains to ski. The surf comes up at unpredictable times. You have to be available to go surfing when the surf's up. That's the nature of the sport. A lot of people lived that way. They weren't necessarily commodity traders.
16:13 Speaker 01 They were cab drivers or doctors. Anybody who could manage their own lives to the point where they could do what they wanted, more or less when they wanted to. And so, after a while, that became the world I've lived in for most of my life. The other advantage is that I've been able to think deeply about a lot of different things, not just commodities or surfing, and give free rein to my imagination or my research in other fields. There was also the broader movement of the counterculture and its association with dropping out. But I wasn't dropping out. I was focused more on the moment than on planning for the future, accumulating wealth or whatever.
16:56 Speaker 01 Michael, out of curiosity, did any of your surfing companions ever get an inkling of the career that you were living? Bill. Nobody knows what it's like to be a trader, except another trader. On the other hand, they knew what I did, that I made my money by trading the markets. It didn't take up a lot of time, and I ran a computer program. Some of them were well-educated and sophisticated enough to have a general idea of what I did. But the people I surfed with had different professions. They had all worked out a way to live, so that they could be free when the surf came up. In my view, I'm not a particularly unique person. I just found a way of making myself available to the surf. Other people had their own ways.
17:41 Speaker 01 In those early days, there weren't a lot of people who did that. You pretty much went through all the stages leading to your career. And I stepped off the bus, I guess. Michael, did you always have the even keel that I see right now? Even when you were, let's say, twenty-one? Were you always pragmatic and thoughtful? Bill. I wouldn't call myself even keeled. I was pretty crazy. Michael, let's go back to trend following. Back in the day, here's what Doncian's doing, and you look at Edwards and McGee, and you got some inclination about where other people were going at that time. And I guess you could have gone the Doncian direction and adopted a fairly simple approach.
18:24 Speaker 01 But in your interview with Niels at Top Traders, you revealed that your approach is a touch more complicated than a typical trend-following price-action system. It seems like you're getting to the same place, but you're getting there in your own unique way. Bill. I was taken by the geometrical aspect of traditional technical analysis. My original idea was to take what was valuable in that technical analysis and turn it into a system so that it was not based on judgment. In other words, if you're drawing trend lines and suchlike from a discretionary basis, there are a lot of different possibilities. And if that changes, then you're in a position of relying on your judgment to decide where
19:07 Speaker 01 to put the trend lines, which leads to the inconsistency that I'm trying to avoid. All I did was take what seemed to be fairly straightforward rules and turn them into a system, a computer program.
19:22 Speaker 01 Michael, do you think that Edwards and McGee put that work together without the systematic computer approach that you did? Bill, I put my original system together largely without computers, because I was one of the first people to have a PC back in 1976. Most of my system development and testing was done manually with CRB, chart books, that sort of thing. You don't need a computer to run a system, you have to think like a computer, in other words, do the same thing over and over. Computerizing the strategy was a matter of taking that logic, those procedures and programming into code. Michael, the fractal wave algorithm is quite a different approach than if somebody was
20:07 Speaker 01 to explain a breakout price action trading system, but it's aiming for a similar outcome. It's taking what the market gives you, it's trying to get the meat of the trend. How would you describe the fractal wave algorithm to those unfamiliar with it? Bill, it's based upon the premises of fractal geometry, where you have nested patterns, a pattern within a pattern within a pattern. The most basic pattern is a zigzag, the price goes up, down, and then up. You can use that as the basis for developing a system that incorporates higher and higher levels of detail. The performance of the system is based upon the underlying theory of these distributions that have fat tails.
20:50 Speaker 01 Although it was attractive to design this around the fractal wave algorithm, that's obviously not a necessity. Michael, it worked for you, you figured it out. Bill, I was working with a friend of mine, he's the one who came up with the logic behind the fractal wave algorithm. We started off by trying to automate the Elliott wave, which was popular at the time, but we found out that it was impossible because the Elliott wave relies too much on discretion to determine where the waves are. What came out of that was a simpler algorithm, which is more like the Dow theory, in which you have a series of higher highs and higher lows, and a series of lower highs, and then
21:32 Speaker 01 those make a larger pattern of higher highs and higher lows, which make a still larger pattern of higher highs and lower lows.
21:42 Speaker 01 The fractal wave algorithm was essentially the automation of the Dow theory that provided a substrate for determining where you would put your entry orders and your stop-loss orders and so on. The fractal wave provided a structure, but it wasn't literally a system. It's a structure that gave you various options as to where to actually place your trades. Michael, is your timeframe weekly bars? Bill, my first system was daily, but after a few years it became less effective when I started exploring the fractal wave algorithm. My first idea was to trade the short-term system in the direction of a long-term indicator.
22:24 Speaker 01 What I discovered was that I might as well trade the long-term indicator. In other words, instead of taking pieces out of a trend, I'd try to get as much of the trend as possible. Obviously, that exposes you to a bit more risk, but the risk is mitigated by trading a number of markets. I trade about forty different markets, and it's less onerous to trade off the weekly charts. Also, it seemed to be more in tune with the actual market fundamentals, because after all, whatever we do in commodities is based upon the cash markets. I think of myself as a trader who believes in the fundamentals, but I don't trade directly based on those. I trade on the idea.
23:07 Speaker 01 For example, when the price of copper goes up, people start digging new mines, which leads to oversupply and so on. You have these cycles related to particular commodities that sometimes play out over years. If you're trading longer term, you're more in tune with those longer-term cycles. That's essentially where I ended up. It was partly a matter of convenience, but it seemed to match the market better and avoid a lot of the noise. Michael, there's no doubt that what you've said should resonate with people who claim to be trend-following traders, but when I ask them about their favorite timeframe, they tell me it's five minutes. Bill, they're living in a different universe.
23:50 Speaker 01 I have a good friend who's a high-frequency trader, and I know enough about what they do to realize that the dynamics, the theory, the behavior of the markets, all of that is different than long-term trading. Michael, I would think that if people want to be inspired by you and take a stab at trading, trying to emulate your path makes a lot more sense than trying to emulate the high-frequency path. Bill, if you look at the people who've been around for a long time, most of them have gravitated toward longer-term trading. It's partly because high-frequency trading's a hard game. There aren't that many people who are successful at it. According to my friend, who's been in it since the beginning, when it started out, it was pretty easy because nobody else was doing it.
24:36 Speaker 01 It was the same as when I started out as a systems trader. You had an advantage over the average trader because you had the technology that wasn't being widely applied. Apparently, high-frequency trading is tough these days, and most of the people who are doing it are more market makers than they are traders. If I were thinking about getting into the business now, high-frequency trading would be the last place I'd look. Michael, there must be some reason that when people first enter this world, they think this short-term stuff is the direction to go in. I'm like you, I think, "Five minutes, what am I doing? I'm going to be glued to the screen, I'm going to be stressed, it's nothing I'd want to do."
25:21 Speaker 01 Bill, that's a good point. For instance, one of the things that was popular when I was in my formative years was the Edward Thorpe book, "Beat the Dealer." It was obviously a trading system, but I asked myself, "Do I want to sit in a smoky casino all day and all night doing this stuff?"
25:41 Speaker 01 I naturally gravitated toward methodologies that required the least amount of work for the most amount of gain. At that time, the commission rates were unbelievable. The costs you were paying for slippage were high. There were a lot of structural things in the markets that mitigated toward trading longer term. It was too costly to trade short-term. Nowadays, it's a bit different, but nevertheless, you're still having to deal with the noise. And again, it requires a lot of attention, computer power, and you've got to be next to the exchange, all that sort of thing. It's literally another world from the one I live in. Michael, let's talk about your personal psychology.
26:24 Speaker 01 You've already talked about surfing and a different lifestyle, about not wanting to be in New York City or Chicago with all the players. Obviously, you figured out how to do it your way and it's worked well. How did you instinctively know to avoid becoming immersed in the group think? Bill, it was well-known then that ninety-five percent or so of traders lost money. So the idea was that if you're doing what the vast majority is doing, you're obviously not going to be successful. It was important to try to insulate yourself from being sucked into that logic when you read the commodity news, or whatever, which is always out of date anyway. Plus, I didn't want to be a floor trader where I'm coming in every day and yelling and screaming at everybody.
27:09 Speaker 01 I wanted to live a more relaxed lifestyle. Michael, were you the first CTA? Bill, I was one of the first. There was a group that centered around Commodities Corp. on the East Coast. They were sort of independent, following Don Cian's lead. But we had a group in San Francisco that was more loosely based. We didn't communicate that much, but there was a handful of us who were getting into the business. I was in the business before it was regulated by the CFTC, before there was a CFTC. I was in the founding group who, by and large, at least on the West Coast, made independent discoveries through talking to each other.
27:52 Speaker 01 There were a lot of people in the aerospace industry who had mathematical backgrounds, so that appealed to them. It's hard to say who was first. Michael, when you first wrapped your arms around the idea of trend following and knew that you had a chance to make enough money to do what you wanted for the rest of your life, how did it feel? Bill, the most important thing for me was to be able to support myself without working too hard and to provide the time for me to surf and live a life of intellectual freedom. I wasn't focused on the money because I didn't care about it that much. That's still the case. I was more interested in maximizing my leisure than I was maximizing my income.
28:33 Speaker 01 Michael, let me take you back even further to a foundational thought. I talked to the psychologist Alison Gopnik a while back, who has written about Bayesian babies. The idea is that babies learn by seeing one thing and following it. And if it keeps feeling good, they keep going in that direction. I know your early background was in Bayesian decision theory. It's not something you learn formally in school, but when one starts to understand this Bayesian thinking, it makes perfect sense. Bill. The Bayesian decision theory that I took was a technical and sophisticated methodology that has not found wide application, at least not in business. You're right, it's more a way of looking at the world in probability theory.
29:18 Speaker 01 It's a thread that's been with me throughout my life. I was convinced early on that probability was epistemological, not ontological, and that's influenced my view of probability. But this is not related to what I'm thinking about in terms of trading. It's a parallel interest that I've had.
29:37 Speaker 01 Michael. In your trading, were you always of the mindset that your system, the fractal wave algorithm, would be applied uniformly across markets? Bill. That's right. My original system was not fractal wave, but by the same token involved trend lines and support and resistance, the basic Edwards and McGee patterns. The idea of it being universal came from the fractal wave algorithm, because it was a way of decomposing data, and that applied to any data stream. I've applied it to other markets, such as India and Japan. Not that I've traded those markets, but I've tested it, and it pretty much works on everything. Obviously, it works better on some things than others,
30:21 Speaker 01 because the markets have different histories. But if you were to give me a market and say, "Would you trade these without testing?", I'd say, "Yeah, apply the same system, off we go." I have confidence that it would work the way it has for other markets. Michael, when you're having a good year and you're making a lot of money versus another year where you're losing a lot of money, what emotions do you feel, given those different states of the success or lack of success of your system? Do you feel the same during these periods, or is there something different internally? Bill, it's hard to totally insulate yourself from it. To some extent, I feel more comfortable in down markets than I do in up markets.
31:05 Speaker 01 Michael, clarify, you feel better when you're losing money than making money? Bill, yeah, I have an idea of where it's going and how it's going to end. Whereas when I'm making money, the sky's the limit. The uncertainty is greater when you're making money than it is when you're losing money. In the sense that you're emotionally reacting to uncertainty, then it's sometimes a bit more comfortable when you're losing money. It's because you're being whipsawed, you're being grounded by trades that are getting in and out, in and out, and it's not exciting. And it tries your patience, because most of the time the markets are in drawdown. Only a relatively small fraction of the time are they making these runs where you're making a lot of money.
31:52 Speaker 01 Michael, I've talked to a lot of your peers, many of whom have been around since you started, but you come at this so differently. When you compare the correlation of performance with other CTAs over time, have you been tightly correlated? Bill, my performance could be used as an index of CTA performance. And of course, it's trend-following performance. We don't make money because we're smart. We make money because the markets give us those opportunities, and we have the discipline to follow a system. Of course, not all systems are going to work. I've never quite figured out what makes one system better or worse than another. But the people who've been around for a long time have honed in on the same timeframe
32:36 Speaker 01 and the same basic strategy. It's a Darwinian process that weeds people out. For instance, most money that's in managed futures is in trend-following systems. And that's because the other methodologies haven't survived in competition. You have to wonder who the trend followers are taking the money from. Once again, it comes down to fundamentals. We're selling insurance to people who are producers or consumers, who need the product and are willing to lock in profits. It comes down to a classical arbitrage game in which we're willing to accept risk and take it off the shoulders of the people who don't want it. It's all pretty simple.
33:18 Speaker 01 After all these years, it's gone through a long evolutionary process, and I think it's pretty much stabilized now.
33:27 Speaker 01 Michael. When I first started researching everything I could find on trend following, sometime in the 1990s, one of the most interesting things I observed is it seemed to me that the best traders in the trend following space were 100% systematic. But when I went through all the disclosure documents from the CFTC, there was always, "We're 95% systematic, but 5% discretion." All these trend following traders were saying they were 5% or 10% discretion. And I was thinking, "I don't believe this. This is marketing to appeal to somebody." If you're a systematic trend following trader, you're going to believe in the system. Yet they were all saying they were 5% discretionary.
34:13 Speaker 01 I'm curious to know if you've always been 100% systematic. Bill. The people I know are all 100% systematic. That 5% discretion comment might be a marketing ploy. The number one realization is the need to stick with your system and to do what it tells you to do. Michael. Did you ever play with discretion early on? Or wonder if it could add some extra value to your system? Bill. No, I don't know that I was ever interested. I saw clearly that 95% of traders lose money, and it was pretty obvious to me that they were mainly discretionary. I had no confidence in my own abilities. I may have tested them out a little bit,
34:58 Speaker 01 but I never had the psychological makeup or even the information to succeed as a discretionary trader. Michael, the Warren Buffett path didn't intrigue you? Bill, Warren Buffett does what I do, really. I mean, he's consistent. He sticks with his trades for years. He's a long-term trend follower. One thing that characterizes a so-called discretionary trader is that he's got to have the action, he's got to be in the markets. It's a psychological need that he's satisfying. It's not irrational. A system trader is one way of being a long-term trader, and obviously, the best way to trade the markets is to put your money in an index fund and let it ride.
35:41 Speaker 01 Michael, we've talked about some of your early stages, but beyond going to school, getting those early jobs, and being exposed to the computers at the Air Force, was there anybody along the way who was influential in the development of your trading? Bill, the people I worked with at the think tank had a unique way of approaching modeling. We were at the cutting edge. This would be the late 60s and early 70s, the height of the Cold War. There was a lot of money going into these new modeling technologies, and this was the first stage of applying them. We were doing a lot of original work, much of it top secret. There's a limited number of approaches to modeling various phenomena, and most of them came into being in that era.
36:26 Speaker 01 I read a book not long ago, The Physics of Wall Street, which talks about the various physics models and mathematical models that were being applied. We knew about every one of these models back in the 60s, and many of them had been resurrected. For instance, deep learning is like neural nets. It's a continuation of a model that's been around for decades, and this is also true with other models.
36:53 Speaker 01 These models have become careers, and people specialize in the various types of modeling, but we were much more ecumenical than that. We selected the model to fit the task, not selected the task to fit the model. We call that model shopping, and that's what people do nowadays. They're educated to apply certain kinds of models. Then they take that model and say, "Okay, I'm going to apply this to commodity trading," or whatever, as opposed to selecting the appropriate model for a specific problem. Much of what I see today in terms of modeling hasn't changed in years. We're going into probably the second AI winter now. The hype around AI started back in the eighties, when everybody thought machines were taking over.
37:38 Speaker 01 And now we're hyping AI. Computing power has expanded so much, but data mining is not thought. Human beings have creativity that computers are incapable of. And that's going to be true for the foreseeable future. If you want to see what AI does, go online. And you'll see all these ads popping up for something you've already bought. Is that intelligence? Michael. One of my favorite guests on my podcast has been Robert Alman, who won the Nobel Prize for game theory. I was a little petrified to talk to this ninety-year-old Israeli game theorist. But what was so great about him was the way he explained things like mutually assured destruction.
38:22 Speaker 01 Look, we had to have the bombers up there ready to go for forty years straight. That's what kept the peace. It was one of those lightbulb moments where I thought, wow. He took all the math that he has in his head, that the average person can't understand, and simplified it in a way that would make sense to anyone. Bill. That's right. We were doing sophisticated modeling. But by the same token, we understood that in an actual nuclear exchange, most of that stuff wouldn't work, it would be chaos. You had to keep up with that game because the other side was keeping up with the game. That was essentially my understanding. That you were in a situation where you had to do it.
39:05 Speaker 01 And what looked like something that was counterproductive, say to the public, was actually necessary in terms of the situation at the time. Michael. As we wind down, I want to look ahead. Because one of the favorite topics of the media, about every five years, is the trend following is dead. It's gone, it's over, they're all losing money, it's never going to work again. And then something happens. This is a repeatable pattern. You've been in this industry for decades. If you had to look ahead, how do you see a strategy of trend following unfolding for the next fifty years? Bill. It'll change in terms of the particulars, I suppose. Michael, you mean what markets are traded perhaps?
39:51 Speaker 01 Bill. I don't know. Obviously, new markets are coming into play, and old markets are going to become inactive. But the basic trend-following strategy relies on fundamental characteristics of human psychology and economics. As long as there are markets, there will be trend-following strategies, and the same underlying mechanisms that cause those to be viable will persist. My current system has been virtually unchanged in over thirty years of trading. I've tweaked it a little bit here and there, but the point is it keeps working. And the reason it works is not because of the system itself, it's because of the existing economic environment. Let me put it this way.
40:35 Speaker 01 When I look at the market behavior, I don't see anything that I didn't see fifty years ago. In fact, I've seen markets like sugar and cocoa go bananas, seen cotton go up limit two weeks in a row, and then go down limit two weeks in a row. Things that would be astonishing today were not so astonishing back in the seventies. But by and large, the markets behave the same as they always have. Michael, if you had to look ahead and say, "Well, there's going to be trend-following strategies, but there might be changes in the margin", would you also see something like the forty percent winners, sixty percent losers? Will that type of philosophical foundation still be a part of trend-following?
41:19 Speaker 01 Because we don't have the ability to predict what's going to be the next big trend. Bill. There are some general parameters that will continue to persist. That's the sweet spot in the markets. It's almost as if the markets are going to extract maximum pain from traders, and any strategy that capitalizes on that pain is going to continue to make money. In other words, it's back to psychology. Most people are wired to do the wrong thing when they're trading the markets. That's not going to change. Michael, are you ever going to retire? Bill, I've pretty much retired now. Michael, but you're still trading?
42:01 Speaker 01 Bill, for my own proprietary trading, but I'm not holding myself out. I've withdrawn my membership of the NFA and CFTC. I'm not trading for clients, my own money. Michael, will you ever stop that? Bill, probably, I'm getting close to that. Because even what little I'm doing requires that I stay engaged on a daily basis. Michael, there must be a part of you that still loves it. Bill, less and less. I've got enough money, just put it in an index fund and forget about it. Michael, I've taken you through all kinds of territory and I appreciate you giving me some flavor.
42:44 Speaker 01 Consciously, I did not want to take you on a linear path. Bill, I appreciate that. I was apprehensive about having to tell my story all over again. But I enjoyed this much more than I thought I would.
43:02 Speaker 00 I see a time when those awake will understand how to make money in up, down, and surprise markets. Whether new trader or experienced, college student or financial advisor, protecting against a crash or just trying to make a lot of money, trend following offers everyone an answer in uncertain times.
43:27 Speaker 00 To get started immediately, send me an email, [email protected] . I will send you the right trend following steps to take, along with my free video. But if you want to buy and hold, trust the government and trust Wall Street, this is absolutely not for you.
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