Guiding Principles of Trend-Following

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."

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