In order to make money on my money, I started to invest with (who I thought were very successful) hedge fund managers and trend followers. I invested “luckily” with Monroe Trout as well as Julian Robertson. I did not know the questions to ask; rather, I basically chased their prior returns.
In retrospect this was a mistake and yet also a great lesson.
Going back to my first two hedge fund managers that I allocated to in 1994, a valuable lesson was to be learned. Julian Robertson from the 1980s had a compounded annual return in the 20 percent-plus range. All I thought about was the rule of 72. Yes, I was blinded by greed and thinking it would be easy. I had no concept of how he was managing the risk nor even worried about it. How could a guru lose money, I thought?
The rule of 72 is how many years until your money compounds. You divide the percent returns by 72 and this determines how many years for your money to double. I was honestly blinded by greed. The interesting fact is twofold and I learned a fantastic lesson in investing. First of all, there are no gurus, and second, never allocate more than 5 percent of your net worth to any idea or money manager, including me.
I invested $200,000 with Julian Robertson through a feeder fund in 1994. All I could think about was I am going to be rich. I was doing the math of 20 percent returns and thinking all the way of compounding my way to wealth. Well, not everything ends as you planned it. Things were proceeding nicely in 1995, 1996, and thereafter until 1998. In 1998 there was the Asian contagion as well as the Russian debt crisis.
Unfortunately Julian Robertson made a big bet on borrowing Japanese yen and buying U.S. Treasuries. For years this trade was a no brainer until Mr. Murphy entered the reality. The Japanese yen took off in value and the borrowing rate changed dramatically, and quickly this trade was a disaster. All of the years of compounding money were shot and big losses shot up. In shock (thank God), I closed out my investment with Julian Robertson.
What did I learn? Very simply that there are no gurus and that anything can happen. I still made money but did give back a lot of my profits.
On the other hand, Monroe Trout was still grinding out profits irrespective of the stock market. I also invested $200,000 with him in 1994. The account just kept on growing. In 2005 or 2006, after years in the market, Trout decided to retire. My $200,000 had compounded over the years after taking some money out to approximately a valuation of $1,400,000. This taught me the lesson of compounding money. As Jesse Livermore stated, patience is what can make money. In all truthfulness it was rather easy with Monroe Trout. There was not a lot of volatility or aggravation. In retrospect it grew to a big percent of my net worth and should have taken profits off as it was compounding. Once Trout decided to retire, I thought to myself, thank you and time to move on.
To highlight the dangers of simply chasing returns, in 2011 there was a manager called Dighton who had a great record. On a simplistic level it would have been easy to invest with him. Over the last six years or so he compounded money at around a 30 percent rate. Many naïve investors threw him money and were blinded by his returns. Dighton was managing upwards of $200 million dollars. In July 2011, however, Dighton blew up and lost 80 percent of his fund. Dighton was a countertrend trader who blew up over one trade with the Swiss franc. Think about it, six years of hard work to be blown up by one trade.
This is not unique. I remember in 1998 that Niederhoffer, a so-called “guru,” was compounding money for years. Many had no idea what he was doing other than printing money. Until one day in late 1997 he made one bad trade after another and later blew up. Niederhoffer believed he was right and the market was wrong (even though he was eventually right). In the meantime he blew up and left a debt of approximately a $20 million margin call. Institutional investors are no better than most when allocating to commodity trading advisors and hedge fund managers. The same greed is evidenced in institutional investors. I learned over the years not to be like them. As it is easier to buy when a commodity trader or hedge fund manager is doing well, too many do this. There is a herd mentality with institutional investors. The bigger the fund, the more confident they are in not just generating returns but the safety of their investments. This axiom was proven wrong in 2011 with John Paulson's funds. Paulson had a fantastic run when he called the housing crisis. He is the founder and president of Paulson & Co. Paulson became a billionaire by short-selling subprime mortgages during the housing crisis in 2007. He personally made $3.5 billion that year. Institutional investors flooded him with their money to manage. However, in 2011, he made various bad trades in banking stocks such as Bank of America and Citigroup. I conjecture he got caught up in the fraud of the Chinese company Sino-Forest Corporation, which further tarnished his record. His flagship fund, Paulson Advantage Fund, was down over 40 percent as of September 2011. Using this as an example, bigger is neither always safer nor better. Many institutional investors buy the equity highs and sell the equity lows. So many of these investors lose money even with profitable hedge funds and commodity trading advisors. They do not have the patience to permit compounding money over time to occur. They want their profits now!
What I do is the opposite of most investors and institutional investors. I buy the drawdowns of commodity trading advisors who have done well for years, who understand and prepare for risk, yet in the current environment have a drawdown. To me it is pretty much common sense and somewhat of a way to mitigate the inherent risks when investing. This is counterintuitive to how most investors think. However, nothing is perfect. As in trend following, you never buy the bottom. Because a commodity trading advisor is experiencing a 25 percent drawdown, for example, there is absolutely nothing promising you or guaranteeing you it will not get worse or even that the commodity trading advisor could blow up. This is the reason that in trading I risk a small percentage on any investment or allocation. I try to take a low-risk bet when investing in a hedge fund or a commodity trading advisor. I accept the risks and the uncertainty. I do not sit month in and month out praying or hoping. I set the trade and say to myself, let's see how this will look in 10 years. Don't get me wrong, I do my extensive due diligence before I invest. I speak to the managers on a current basis and monitor them daily when I have the luxury of having a managed account with them. I am not chasing quantitative numbers solely. The qualitative is much more important. The qualitative are many matrixes based on integrity and honesty. When I speak to a commodity trading manager, I want to understand the risk measures they utilize. These risk and money management parameters dictate to what degree the manager “tries” to prevent losing my family's money. It is not pertinent to me what exactly gets them into a trade or their exact system. The most important issues are the risk and money management aspects. After the MF Global debacle a major source of interest is where the money sits if I invest in a fund, as well as how many futures commodity merchants they have accounts with. These have become major issues and aspects of risk management that prior to MF Global I truly did not consider. As trading is my passion, besides researching and building models for me to utilize for my own trading, a good part of my day is speaking to other traders and brokers. I am not seeking any trading tips. I am seeking new trading talent that I am not familiar with. I am always exchanging thoughts and ideas with others who invest in commodity traders like me. There are two individuals who I feel fortunate to have come in contact with, Harry from Texas and Alan from Chicago. These two individuals get it more than any institutional investor I have ever spoken to. In addition, I always try to surround myself with people that have considerably more experience and knowledge than me. There is a broker in Chicago that has a small group of very experienced clients, and his specialty is to allocate to commodity trading advisors. Todd Fulton from Pioneer futures has his ear to the pavement and seems to know everyone in the industry. I have had numerous conversations with him and have learned a great deal.
I have been to numerous conferences at different times such as the MFA conferences, Alphametrix, and the CTA Expos. I
have had coffee and drinks with Sovereign Wealth fund managers as well as large fund of funds managers. Comparatively, the individuals from Texas and Chicago as well as Todd have so much more vast experience and knowledge. Harry from Texas has been investing since 1987. He told me one of his first managers was Paul Tudor Jones. All one has to think of is the compounding over the years Harry has accomplished. One manager whom I know went through a terrible drawdown in one of his programs from February 2009 till May 2010. He told me about a client of his who bought this drawdown and without mentioning names I understood who it was. Buying drawdowns and diversifying are some of the tools of investing with commodity trading advisors I have used over the years.
At the last Alphametrix conference in Miami Beach, I had the luck to sit at a presentation of a commodity trading advisor, and Alan from Chicago sat down with us. I had never met Alan before and was honored he sat in on the meeting. He was giving me and the commodity trading advisor great insight into many trading issues and ways he has profited over the years. It was a great lesson.
It is not easy to find the upcoming new managers. It has to be your passion. It is not just about going to conferences, as many family offices or fund of funds try to do. Nor is it quantitatively looking at databases. As much as I strongly recommend Iasg.com, Autumn gold, Altegris, Alphametrix, and Barclays, however, the best is to meet managers face to face. Both the CTA Expo and Alphametrix conferences offer that possibility. Meeting someone face to face is personal and much can be gleaned.
Contrary to the institutional investors who think they are “safer” to invest in the huge funds such as Winton or Transtrend with their billions of dollars under management, I feel it is more prudent to invest with a manager who is a PHD—Passionate, Hungry, and Dedicated—who is not managing a ton of money. When a money manager is trading less money, he is more nimble and can trade markets the aircraft carrier funds cannot trade due to liquidity issues. It would be impossible for a large fund to try to trade cocoa or orange juice. It would be like an elephant in a china store. Many investors were deluded in 2011 because many of these big funds did well because of the Treasury markets. The big funds can only trade the biggest markets such as stock indexes, currencies, interest rates, and so on. In 2010 one of the big winners was cotton. This was a market that the big funds could possibly get into but exiting would have been difficult and full of slippage. Investing with other commodity trading advisors is an essential aspect of my way of compounding wealth over time.
As in your own trading as well as investing with money managers you need an exact plan.
■ Have a Plan and Follow it
It is surprising to me that such a large number of traders who enter the markets have no plan whatsoever or no plan based on risk. Too many traders do not have the vaguest concept of how they plan to succeed in the long run. They are so anxious to actually get started that they have not thought of any of the preparations that are necessary. In the futures markets they are cannon fodder for the 10 percenters who take money out of the market over time. This lack of preparation explains the reason for the extremely high rate of failure of traders. The next great danger in trying to trade for a living is the danger of high expectations. To highlight this example, I had a conversation with a new trader who told me he expected to make at least 25 percent a year on his money. I asked him if he had ever heard of the rule of 72 (how many years it takes to double your money). Clearly he never heard of it. I enlightened him and expressed to him that some of the best traders who manage the risks, who have a plan, ONLY make, over time, on average 15 percent. These money managers are managing in excess of hundreds of millions of dollars. Traders that focus too much on the money end up losing their money. New traders need to focus on their learning and perfecting their plan to be consistent. I cannot say that enough!
As far as my personal trend following journey, I wanted to learn from my broker who was succeeding at his firm and what they were doing right. The most successful client of the brokerage was a dentist. He was not a Harvard graduate nor a partner in Morgan Stanley or Goldman Sachs.
■ A Lesson in Compounding: The Dentist
The dentist invested $200,000 in a robust trend in 1979. He let that money compound over time. Today the dentist has pulled out over $12,000,000 over the years and has a $5,000,000 trading account as well as accounts for his children and grandchildren.
The dentist did not have any magical holy grail formula!
He is a trend follower who had a simple robust methodology and, more importantly, knew how to properly condition his thought processes to get through all the tough drawdowns and long periods when he did not make money (even though he complained about it).
The dentist was the exception, though. Most clients of the brokerage were not successful. The vast majority of them lost money and ended up quitting. I did not want to be one of those unsuccessful clients that lost money and quit. My goal in this book is to help you to not become the typical trader who loses money and quits.
My goal is to help traders like you to achieve your trading goals, so that you, too, can live the lifestyle you want, afford to buy the things you want to have, be more relaxed, and have more time for the things you enjoy doing and that are important to you. Do not expect overnight success. There will be losses and drawdowns. You will need to work on your patience and discipline. The dentist's goal was, and still is, compound money over long periods of time.
I want to teach you to think like a successful trend follower. I am giving you exactly the methodologies I have used on a daily basis for the last 18 years. They are not any magical holy grail; rather, they are robust ideas that give you the ability to make low-risk trades and try to catch trends when they are present.
You can take my ideas and apply them to your own personality and risk tolerance. Your trading must match your personality. An example of this is Dave Druz, who learned under Ed Seykota. Dave took ideas from Ed and matched them to his own trading. Both of them are trend followers, yet they trade different styles matching their personality.
Hopefully this will be the same with you as well. I will share with you and instill in you all of my knowledge gained over the last 18 years. However, we are dealing in the unknown, and there are also risks when trend following. You need to apply your own risk tolerances.
If you are interested, I will teach you how to invest with other trend followers via my courses or webinars. The reality is that some years I outperform the money managers I invest with, and then there are years I underperform them. I am not on any ego trip as my ultimate goal is to compound money over long periods of time and diversify. I do not care if I do better than the group of money managers or if some do better than me. The bottom line is that I am compounding my way to wealth, and this is the key to success.
I do a combination of things in order to try to smooth out my returns and compound money over time. As I have previously stated, I invest with groups of trend followers as well as do my own trend following. There are many who believe that all trend followers are the same. I know for a fact that this is not the case as I have money invested in various money managers via managed accounts. Sometimes we can be in the same trades. However, we get in or out at different points or have different position sizing, thus we generate different returns. My goal is to compound money over time.
I do not allocate more than 5 percent of my family's net worth to any trading idea and look to let the odds work over time. In many cases I allocate even less with the goal to diversify.
The fact that I can compound money over these years means you might be able to as well if you have the mental fortitude! The dentist compounded money over all of these years and you might be able to as well!
CHAPTER 1
Get a Savvy Start
Can You Really Make a Living as a Trend Follower?
What I have said to countless people is: If I can do this, you can do this. I did not go to Harvard nor is it even needed to succeed as a trend follower. However, i
t will be a journey! Many first-time traders want to start too quickly without a well-thought-out plan. This can be very dangerous to one's financial health. Very few of these new traders are successful right off, and if they get lucky on a trade, this can even be worse for them. They learn not to have a strong appreciation of the inherent risks in the markets. What does that help, though, if you have learned via a mentor or had a pedigree education at another trading firm? Many of the traders I have invested with over the years have come out of other successful organizations and have learned there. I had people help me along my journey. Not with the elusive holy grail; rather, how to think, how to accept the inherent risks in the market, and how to implement additional risk filters in my trading models.
Understand, trend following is full of risks, and you need to risk your money to trade. I assume you heard this warning several times: “Don't trade with money that you can't afford to lose.” You might think that this is just the typical disclaimer that every professional in the trading industry has to use, but it's not. It's much more. You need to be realistic and start slow. I would not suggest you quit your day job to start trend following. Even the most successful trend followers who have been trading for decades on average over time return approximately 15 percent. What makes you think you will outperform them?
The Trend Following Bible Page 3