One of our favorite bloggers, Barry Ritholtz, had a post up yesterday that struck a cord for us entitled, “Take the Loss.” While much of his commentary there related to the macroeconomic climate and the politics therein, the message of “taking the loss” crossed over into the realm of managed futures quite nicely.
The dominant strategy in the managed futures space is trend-following. It’s where managed futures started out, and the strategy you’ll see used by some of the biggest CTAs out there. Despite its prevalence and ability to attract assets, there’s one component to investing with a trend-follower that most can’t seem to wrap their minds around- I’m going to have more losers than winners.
Why in the world would you invest in something that loses more often than it wins? This ties back to a newsletter we wrote in 2010 on the Percent Profitable Fallacy. Yes, you may lose more frequently than you win, but in our experience, those wins are typically larger than the losses [Disclaimer: Past performance is not necessarily indicative of future results.] In this light, yes, trend-following investors are asked to take a loss more often than not, but in exchange, their wins are, typically, much more rewarding.
This stands in stark contrast to the “Too Big to Fail” banks, prop desks, and option sellers of the world, where the model is to rack up as many wins as possible. The problem they face is that, because of the risk taken on in those trades, their losing trades are typically very, very big. Like, $2 Billion big. Sometimes.
Of course, there are no guarantees involved in selecting a trend-follower over an options seller or any other investment. Futures trading presents a risk of substantial losses, and no matter what strategy you go with, there’s always a chance that they’ll get caught on the wrong side of the market. However, in our opinion, the risk management involved in trend following mitigates some of that risk.
The key to investing with a trend-follower without losing your sanity is to put this uncomfortable loss into perspective. Keep in mind that taking the loss is part of the deal- the question is whether those losses are recouped by the wins you take along the way.