Personal Finance

Return to Article

Guiding Principles of Trend-Following

Frank Minssieux

When it comes to philosophies about investing, there are two extremes. At one end are those who purchase their investments and sit on them for the long term, waiting out both up and down markets. We call that buy-and-hold. It is the most prevalent method, often touted by financial advisers who understand the downside of emotional investing.

Others choose to jump into the frenzy, trying to exploit every small up and down wave in the water. We call that daytrading. And while daytraders may benefit from very short-term swings, over the long term they rarely beat buy-and-hold.

But there's another philosophy that shows compelling returns. It's based on practicing preparedness and always being ready with a strategy for how to react when you see that the tide has reached its peak and is starting to reverse. When that strategy is strictly determined by an unemotional, mathematical method, we call that trend-following.

Trend-following has been around in various forms and flavors for more than half a century. In the past, it was viewed as too technical and complicated for the average individual investor. However, with the growing availability of new tools, such as widely accessible data and online graphing, along with new investment vehicles, such as exchange-traded funds, trend-following is becoming more manageable and easy to implement at the individual investor level.

While trend-followers believe there are elements within the buy-and-hold philosophy that are valuable, such as a long-term outlook and the belief that no one -- absolutely no one -- knows how high the market will fly or how far it will fall, they also believe there is a way to improve on the tradition.

While it is true that the stock market always goes up over the long term, there can be major losses during downtrends or bear markets that can take years to recoup. Trend-followers seek a way to minimize their exposure to such losses by using a purely mechanical way of looking at what the market is doing at the present moment and reacting in kind.

Logic, trend-followers say, is not nearly as accurate an indicator as objective data, such as price and volume movements and interactions. In addition, external information, such as earnings statements or interest rates, only make for a "confusion of voices" that tend to lead investors into emotional investing. There is no anticipation in trend-following, only reaction to what is happening now.

As such, trend-followers hold to some basic guiding principles:

• First, the market is always changing, generally moving in trends that, while not predictable, can be detected and measured.
• Second, by recognizing the change, you can react to it in ways that will make the most of an uptrend and minimize the effects of downtrends -- or better yet, benefit from them. How you recognize change is determined by the type of technical indicators you decide to follow. For example, if you are following moving averages, you'll begin to see an uptrend when a faster 50-day average crosses the slower moving 200-day moving average to the upside. When it plunges back under, you are looking at a decline in the market. Whatever methodology trend-followers use, there is no forecasting or guessing, only reaction to trends that are already occurring.
• Third, losses will occur.

Trend-followers are the first to agree that no one individual or system is always right. But for them, the goal isn't about being right. It's about making money. So if you can just check your emotions at the door and watch how the market is moving with a neutral eye, you can detect patterns, make solid decisions, manage the risk, mitigate losses and profit in either bear or bull markets.

Critical then to the philosophy -- and its most noticeable difference from buy-and-hold -- is downside protection.

With a noise-neutral, systematic way to alert you to when a change of trend is occurring -- such as moving average crossovers or broken trend lines -- you can react to that trend by buying, selling or cashing out. When the trend reverses, you react again, creating an inherent form of risk control. You don't have to know why; you simply have to react without wavering from the system, regardless of what your gut instinct says.

Where trend-followers differ from one another is in their execution of the strategy. Some use methods that have them trading on a daily basis. Others follow more macrotrends, identifying only major movements and trading as little as once or twice a year.

Traditional trend-followers adhere strictly to price as the indicator in their analysis. Newer forms of trend-following may add one or more elements, such as volume or momentum, to the mix. They believe the combination makes for a more solid indication of what the market is doing.

Some use trend-following exclusively on individual stocks; others propose that broader indices work better. Some choose a highly technical algorithmic process; others draw trend lines on charts.

More conservative trend-followers stand aside during down markets, while others believe you stay in the market at all times, using a combination long and short strategy.

But they all buy into the key principle: Observe and let the market tell you what to do. No emotions, no interpretations and no predictions. Just the facts. In this way, trend-followers can simply enjoy the game without suffering from the stress and disappointment of "bad" decisions. They trust the system -- and it works for them.

Do you fit the profile? Trend-followers tend to be realists. They typically are highly disciplined, find rules and technical analysis comforting and prefer to take a long-term approach to finances.

Ask a trend-follower what he thinks the market is going to do next, and you're likely to get a fairly terse remark. To quote Winston Churchill, "I always avoid prophesying beforehand because it is much better to prophesy after the event has already taken place."