Fundamental analysis, buy and hold, value investing, CNBC, stock pickers, day trading — stop. Enough. Those typical investing approaches, popularized by media for decades, are not the way to build true wealth. Explore trend following and learn something different.
Here is what the complete Turtle Trader has to say on the subject of what is mean reversion and how following conventional investing methods as recommended by the TV shows and major investment websites may be just like panning for fools gold and are not really true wealth systems.
What is mean reversion? Over the long haul, market prices have a tendency to “revert to the mean.” That is, studies have conclusively shown that when stock prices (or any price, for that matter) get overextended to the upside (or to the downside), they eventually fall back in line with averages. However, stock prices do not exactly snap back into place overnight. They can remain overvalued or undervalued for extended periods of time.
That extended period of time is the sandbar that sinks ships. People who bet on markets’ behaving in an orderly fashion (arbitrage) are panning for fool’s gold. Parker and the other Turtles learned a long time ago from Dennis that the hard thing to do is the right thing to do:
Mean reversion works almost all of the time. Then it stops and you’re kind of out of business. The market is always reverting to the mean except when it doesn’t. Who wants a system like we have, “40% winners, losing money almost all the time, always in a draw down, making money on about 10% of your trades, the rest of them are sort of break even to losers, infrequent profits”? I much prefer the mean reversion where I have 55% winners, 1% or 2% returns per month. “I’m always right!” I’m always getting positive feedback. Then, maybe in 8 years, you’re kind of out of business, because when it doesn’t revert to the mean, your philosophy loses.
Hearing Parker’s Southern cadence as he preaches about mean reversion hits home. Consider an example that makes his point: Let’s say an investor gives a trader money because his two-year track record shows he made 2 percent every month with no down months. Six years later, that same fund blows up and that investor’s retirement is gone because the strategy was predicated on mean reversion. It is human nature to believe in mean reversion, but as Parker says, “it just is a fatal strategy of trading the markets.”
Why Mean Reversion Feels Safe and Is Not
Parker’s framing of the choice is the most honest comparison between mean reversion and trend following available from any practitioner. He is not dismissing mean reversion as conceptually wrong. He is acknowledging that it works most of the time, that it produces the psychological rewards of frequent wins and steady returns that trend following does not, and that it eventually, inevitably, produces catastrophic failure when the market stops behaving as the model assumes it will.
The 2% per month, no down months, 55% winners trade is the trade that investors line up for. It feels like a superior system. The performance metrics look better on every conventional measure: higher win rate, lower volatility, smoother returns, more consistent positive feedback. The only problem is that those metrics measure the system’s performance during the favorable regime and say nothing about what happens when the regime ends. LTCM produced years of consistent returns before a single unfavorable regime change destroyed it. Madoff produced decades of consistent returns before the structure underneath them collapsed. Both were predicated on an assumption about how markets would behave that held until it did not.
Trend following’s 40% win rate and frequent drawdowns look worse on every conventional performance metric during normal periods. But the system does not blow up. When markets stop behaving in the orderly way that mean reversion requires, trend following is positioned for exactly that discontinuity. The periods that destroy mean reversion strategies are the periods that produce trend following’s largest returns. The asymmetry is structural, not accidental.
Parker’s observation that the hard thing to do is the right thing to do is the complete psychological description of why trend following is systematically underutilized. Accepting a 40% win rate, frequent small losses, extended drawdowns, and infrequent large profits is psychologically difficult. Conventional media and investment education reinforce the preference for systems that feel better: more wins, smoother returns, regular positive feedback. The mainstream approaches feel right. They are wrong. The trend following approach feels wrong. It is right.
Frequently Asked Questions
What is mean reversion and why does it seem to work?
Mean reversion is the tendency of prices that have moved far from historical averages to eventually return toward those averages. It does work most of the time. Markets do spend more time in range-bound conditions than in sustained trend conditions. This means mean reversion strategies produce frequent small gains under normal conditions, which creates a performance record that looks impressive over short to medium time horizons. The problem is the failure mode: when a sustained trend develops and prices do not revert, mean reversion strategies hold and add to positions that are moving against them, producing losses large enough to wipe out years of gains.
Why is a 2% monthly return with no down months a warning sign?
Because no legitimate trading strategy produces returns that smooth over all market conditions. Consistent monthly returns regardless of what markets are doing typically indicate either a strategy that has not yet encountered its failure regime, or outright fraud. Madoff’s returns were famously smooth and consistent. So were LTCM’s before the collapse. The absence of down months is not evidence of superior risk management. It is often evidence of hidden risk that will eventually surface in a single catastrophic loss.
Why does trend following have such a low win rate?
Because most breakout entries fail to develop into sustained trends. The system enters when a price movement exceeds a defined threshold and exits at a predefined stop if the trend reverses. Most entries fail and produce small losses. The minority that develop into sustained trends produce large gains that more than offset all the small losses. The low win rate is the expected cost of being in position when the large trends arrive. It is not evidence of a poor system. It is evidence of a system built correctly for the payoff distribution that trend following produces.
Trend Following Systems
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