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Trend-Followers Live Above the Fray

Frank Minssieux

The entire concept of trend-following is such that we are immune to the noise and emotion of the market, focused instead on the mechanical and unemotional way the market moves and stretches up and down as it trends over time. We believe that 2 plus 2 always equals 4 whether or not the sun is shining or it is cloudy outside.

And those beliefs allow us to simply "enjoy the ice cream" on our plates in uptrends as well as downtrends, regardless of earning statements or interest rates. Still, an immunity to the emotional side of investing depends on an understanding of market mentality during its major phases.

Let's look first at what defines a bull or bear market. In simplest terms, a bull market is a prolonged rising market, or one that's increasing in overall value, and a bear market is one that is falling in valuation. To qualify as one or the other, the market must have been moving in its current direction for a sustained period of time.

Most analysts agree that, by broadest definition, the market must increase by about 20% of its value to qualify as a bull market and decrease by about 20% to qualify as a bear market -- anything less is labeled a pullback or a correction.

During bull phases the market wants to keep moving up, and the default action is for investors to "buy the dips." The predominant bullishness is evidenced by generally lower volume when the market declines and higher volume when it advances, because more investors view a market retreat as an opportunity to jump in at a better price.

This, in turn, causes the higher highs and higher lows characteristic of bull markets. Remember when it seemed you couldn't throw enough money at tech stocks?

However, when the stock market enters a bear cycle, investors' emotions switch from euphoria to desperation. The market mentality calls for "selling the rallies," thereby driving the bear down further. Fear rules the roost. And inwardly -- and sometimes in loud voices for everyone to hear -- bearish investors chuckle with a clear and present "I told you so" tone.

Let's say you invested $10,000 in the Nasdaq Composite Index at the very bottom in October 1990 and held on until the very top of what was one of the longest-lasting bull markets in history. In March 2000 you would have accumulated $277,000 with a buy-and-hold strategy. That's a pretty tidy return.

However, human emotions being what they are, it is highly unlikely that you would have 1) invested at the very bottom, 2) held on through the crashes and corrections along the way and 3) sold at the very top.

More than one investor bailed out at the worst possible time after the market took a major nose dive, losing 50% to 70% of their investments. Five years later, the Nasdaq is still 54% below its peak in 2000, and those who stayed in with buy-and-hold are only just now beginning to see some recovery in their portfolios.

At best, they are back where they started. At worst, they suffered untold stress watching the ups and downs and possibly gave up investing for good.

Why do traders end up reacting to the emotions of the day? It's the result of more than just the psychology of the markets. It comes down, say behavioral psychologists, to the internal motivation of the individual investor.

Many might say they are seeking financial security, but perhaps they don't want to be left behind when everyone else is profiting, or they don't want to admit they made a mistake when they chose a stock that's heading south. They buy the propaganda issued through daily news and stock picks and are molded by group emotions about one index fund or another. They follow their emotions without even realizing it.

Regardless of whatever psychological forces are at work, evidence points clearly to the fact that emotional investing results in bad decisions. People often don't have the courage to hold out when an investment is falling, and they end up selling at the worst possible time.

If you want to escape the emotional roller coaster, you must be able to:

• Look past what's being said.
• Ignore the headlines.
• Even turn a deaf ear to your own gut instincts.

Trend-followers simply follow market patterns and enjoy watching the daily ups and downs of the market, knowing that they don't have to respond until the numbers tell them to do so. They can more easily extract real market cycles from the noise.

It's a concept, they say, that is inherently less risky than a buy-and-hold strategy over the long term, because it offers protection against a down market. With buy-and-hold in a bear market, it can take many years to merely get back to your starting point. With trend-following, at a minimum, you can step aside or, more actively, sell short to profit from a downtrend.

Trend-followers enjoy all the ups and downs of the stock market by successfully managing the emotions that sooner or later undermine other investors. Yes, it's good ice cream.