Clayton Christensen

The Innovator’s Dilemma by Clayton M. Christensen is a great read for trend followers. Christensen recently offered in an interview:

They were looking at the book [Innovator’s Dilemma] for answers rather than for understanding. They were saying ‘tell me what to do’ as opposed to ‘help me understand so I can decide what to do.’…[Wall Street analysts] are theory-free investors. All they can do is react to the numbers. But the numbers they react to are measures of past performance, not future performance. That’s why they go in big herds. Wall Street professionals and business consultants have enshrined as a virtue the notion that you should be data-driven. That’s at the root of the inability of companies to take action in a timely way.

Christensen clearly outlines a key tenet of the trend following mindset. Trend following is never based on having all the data. It’s based on odds and reaction. Think about it. If you look at a stock such as Yahoo and witness its great rise and decline you can say ‘you should have bought here and sold there’. But isn’t that 20/20 hindsight? No, you simply needed a trading plan of attack before the great rise up and great decline down.

What Christensen is driving at is the notion that you must be able to make decisions in the face of not knowing how the trend will look when it’s all over. You must have a plan to act early before trend direction is obvious to the masses. You must be set and ready to go (and entered) long before the CNBC watchers decide the trend is underway and jump on. Those people are always a day late and a dollar short. Those people are the herds Christensen alludes to. Those people don’t make the money, they lose it. And given that trading is a zero-sum game, the money that those people lose goes directly to the other people with the plans of attack designed to win their losses.

Obey Price

“We know that prices move up and down. They always have and they always will. My theory is that behind these major movements is an irresistible force. That is all one needs to know. It is not well to be too curious about all the reasons behind price movements. You risk the danger of clouding your mind with non-essentials. Just recognize that the movement is there and take advantage of it by steering your speculative ship along with the tide. Do not argue with the condition, and most of all, do not try to combat it.” — Jesse Livermore

“The market reflects all the jobber knows about the condition of the textile trade; all the banker knows about the money market, all that the best-informed president knows of his own business, together with his knowledge of other businesses; it sees the general condition of transportation in a way that the president of no single railroad can ever see. It is better information on crops than the farmer or even the Dept of Agriculture. In fact, the market reduces to a bloodless verdict [THE PRICE] all knowledge based on finances, both domestic and foreign.” — Charles Dow

In response to questions concerning his opinion on where individual markets may be headed, Jerry Parker had this to say:

I don’t know nor do I care. The system that we use at Chesapeake is about the market knowing where it’s going.

What These Four Voices Share

Christensen, Livermore, Dow, and Parker are making the same point from four different vantage points across more than a century. The market aggregates more information than any single participant can possess. Trying to out-think it by accumulating more data or better analysis produces the behavior Christensen describes as the inability to act in a timely way. The correct response to the market’s information advantage is to follow what it is already saying through price, not to compete with it by trying to know what it knows.

Christensen’s “theory-free investors” critique applies precisely to the CNBC herd. Analysts who react to reported earnings, analyst upgrades, and historical performance data are not using a theory to anticipate what the market will do. They are using historical data to decide what the market should have done. By the time they act, the price has already moved. They are paying the price that reflects the information they just received, not the price that will reflect the information about to arrive.

Livermore’s “irresistible force” is what Christensen is pointing toward when he says you must be able to make decisions without knowing how the trend will end. The force is the aggregate of all market participants’ decisions expressed through price. You do not need to know what the force is made of. You need to recognize that it exists and align with it. Don’t argue with the condition. Don’t combat it. Steer along with the tide.

Dow’s passage is the foundational statement of why price is sufficient. The price already contains everything the textile jobber knows, everything the banker knows, everything the railroad president and the crop specialist know. The individual analyst who believes they have better information than the price is claiming to know more than all of those participants combined. Some individuals do know more about specific situations at specific moments. But as a systematic rule for how to trade, the assumption that your analysis exceeds the market’s aggregate knowledge is not defensible. The price is the superior signal.

Parker’s formulation is the operational implementation of all three. The system is about the market knowing where it’s going. Not the analyst. Not the investor. Not the portfolio manager. The market. The system follows the market’s stated direction through price. The analyst’s opinion about where the market should go is irrelevant to the decision.

Frequently Asked Questions

What does Christensen mean by “theory-free investors”?

He means analysts who react to historical performance data without using a theoretical framework to anticipate future conditions. They are data-driven rather than theory-driven, which means their data is already priced and their reaction is always late. A theory-based decision, one that identifies a structural market condition likely to persist regardless of what the recent numbers show, can precede the market’s full recognition of that condition. Reacting to what the numbers say about the past cannot.

Why did Livermore say not to be too curious about reasons behind price movements?

Because investigating reasons consumes attention that should be directed at price behavior, and the reasons often arrive after the price has already moved. The fundamental analysis that explains why a market moved is typically published, researched, and confirmed after the move has occurred. Following the price as it moves, without waiting for the explanatory framework to develop, is the faster and more accurate approach to positioning correctly. The irresistible force behind major price movements is sufficient to know. The reasons for the force are non-essential.

How does Charles Dow’s price aggregation argument support systematic trading?

By establishing that price already contains more information than any individual participant can accumulate. The price at any moment reflects the aggregate of all professional, institutional, and retail participants’ knowledge about the relevant fundamentals. An individual analyst who believes their research adds information beyond what is already in the price is claiming to know more than all other market participants combined. Systematic price-reactive trading accepts the price’s information advantage and uses rules to respond to its direction rather than competing with it through additional analysis.

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