Risk Management

Some mistakenly believe that trend following will cease to work if too many people trade as trend followers. We have addressed this question over the years, but decided to approach the issue from a different angle: human nature and the lottery.

The Lottery

Take this excerpt for example:

The odds of winning the Powerball lottery are more than 80 million to one, a fact that seems lost on most lottery players. A survey taken last year by the consumer group Consumer Federation of America shows over a quarter of Americans believe the lottery is their best chance at gaining wealth in their lifetime. “Many don’t fully appreciate the odds against their winning the lottery,” said Stephen Brobeck, executive director of the Consumer Federation of America. “Some are not aware of the opportunities for even moderate-income families to save and build wealth.” Opponents of state-sanctioned lotteries believe the problem is much deeper. The deputy director of the Council on Compulsive Gambling of New Jersey calls the lottery a national addiction. “It’s culturally OK and socially acceptable to play the lottery,” said Kevin O’Neill, adding that near-wins are “instant reinforcement” to continue playing.

Look at how many people play a losing game like the lottery and still continue to play, day after day, year after year. The outcome of the purchase of a Lotto ticket is based on objective probabilities, but people still play. What are the odds?

• The odds of winning the California Super Lotto Jackpot are 1 in 18 million.
• If one person purchases 50 Lotto tickets each week, they will win the jackpot about once every 5,000 years.
• If a car gets 25 miles per gallon, and a gallon of gas is bought for every Lotto ticket bought, there will be enough gas for about 750 round trips to the moon before the jackpot is won.
• It is three times more likely for a person driving ten miles to buy a Lotto ticket to be killed in a car accident than to win the jackpot.

You have better chance for the following events to happen long before you ever win the lottery:

• Dealt a royal flush on the opening hand in a poker game (1 in 649,739).
• Killed by terrorists while traveling abroad (1 in 650,000).
• Die from flesh-eating bacteria (1 in 1 million).
• Heart disease caused by eating a steak a week (1 in 48,000).
• Killed by a lightning strike (1 in 30,000).

Trend following trading is different. It requires you to accept an understanding of odds. As long the majority consistently play losing games (like the lottery), the same lack of odds understanding will enable trend followers to keep winning.

One reader posted this:

For example, the Canadian 6/49 Lottery has 6 numbers drawn from a total of 49 balls with the numbers 1 through 49 on them. The probability here is 1 in 13,983,816. Before the first ball with a number on it is drawn, or randomly selected, there are 49 balls in the hopper. The first ball is drawn and put aside. After this first ball is drawn, there is 48 balls in the hopper. After the first two balls are drawn, there is 47 balls, or numbers, remaining. This continues until there are 44 balls remaining in the hopper when the sixth winning number is drawn. The Canadian 6/49 draws a bonus ball, which is drawn from the remaining balls after the sixth number is drawn. This last, or Bonus, number is used to select a second tier winner, and has amounted to more than $693,000.00. The Irish Lotto 6/42 has 6 numbers drawn from a total of 42 balls. This brings the odds down to 1 in 5,245,786. The US PowerBall draws 5 numbers from a total of 45 balls. Then, 1 number is drawn from a separate set of balls numbered from 1 to 42. This little detail makes the odds here 1 in 80,089,128.

Have you thought about your trading with this level of precision? Trend followers do every day.

More on why trend following will continue to excel.

What the Lottery Tells Us About Why Trend Following Endures

The question of whether trend following will stop working if enough people do it is answered by the lottery data. A quarter of Americans believe the lottery is their best chance at building wealth despite 80 million to one odds. They play week after week, year after year, with full knowledge that the odds are against them. Near-wins provide enough reinforcement to sustain the behavior indefinitely. The psychology that keeps people playing a mathematically negative game does not change because the odds are published and universally known.

The same psychology that sustains lottery playing sustains the behavioral errors that create trend following opportunity. Loss aversion, the illusion of control, the gambler’s fallacy, the disposition effect, the tendency to cut winners early and hold losers long — these are not errors that education eliminates. They are structural features of human cognition that persist regardless of how well documented they are. People who have read Kahneman, Tversky, and every behavioral finance paper published in the last thirty years still make these errors because knowing about a bias does not prevent it from operating at the moment of decision. The lottery player who understands the odds still buys a ticket. The investor who understands loss aversion still holds a losing position too long.

Trend following wins because it operates on the opposite side of these persistent, structural behavioral errors. It is not a strategy that works only until too many people discover it. It is a strategy that works as long as the psychological errors that create opportunity persist. The evidence that those errors are not disappearing is in the lottery queue at every convenience store and in the trading accounts of the investors who bought Enron all the way down.

The reader’s breakdown of lottery odds by country is the same precision that a trend follower applies to position sizing, risk management, and the probability of entry signals developing into profitable trends. Have you thought about your trading with this level of precision? Trend followers do every day.

Frequently Asked Questions

Why will trend following continue to work even if more people use it?

Because the behavioral errors that create trend following opportunity are structural features of human cognition, not correctable information gaps. A quarter of Americans believe the lottery is their best path to wealth despite published 80 million to one odds. Knowing that loss aversion causes bad trading decisions does not prevent loss aversion from operating at the moment of decision. These errors persist regardless of how widely documented they are, which means the opportunity they create for systematic trend followers persists as well.

What is the connection between lottery psychology and trading psychology?

Both involve people making decisions that are mathematically suboptimal because of psychological biases that override rational calculation. Lottery players continue buying tickets with 80 million to one odds because near-wins provide reinforcement and the cultural acceptability of playing lowers the psychological cost. Investors continue holding losing positions despite clear evidence that the trend is against them because the psychological cost of accepting a certain loss exceeds the rational calculation of expected value. Both groups are choosing emotional comfort over mathematical optimality.

How does understanding odds improve trading performance?

By allowing the trader to evaluate each decision on its expected value rather than on how it feels. A stop loss that fires on a losing trade is the mathematically correct response to the probability that the position will continue declining. A trailing exit that holds a winning trade through a pullback is the mathematically correct response to the probability that the trend will continue. Both decisions require accepting the psychologically uncomfortable option in exchange for the mathematically superior expected value. Understanding the odds makes that trade-off visible and actionable.

Trend Following Systems
Want to learn more and start trading trend following systems? Start here.