I’m sure you’ll agree that more and more conversations with clients focus on their concern about a major correction coming soon. They have a very real fear of the market and its future direction. The deep wounds from 2008 and the “Lost Decade” for stocks in the 2000s have caused them to look for better investments.
Many investors are simply fed up with the status quo and are approaching their advisors about alternative strategies. One of particular interest is “trend following.”
What Is Trend Following?
According to Wikipedia, it’s an investment strategy based on the technical analysis of market prices rather than the fundamental strengths of companies. In one analogy, the market behaves just like the waves of an ocean; a surfer riding a wave has no more control over it than an investor riding a trend. Surfers simply take advantage of forces that already exist for their benefit.
Trend followers do not try to predict the future, any more than surfers try to create waves. The first job of a trend follower is to determine whether a trend actually exists or is substantial enough to take advantage of. Trend followers use different techniques to determine the trend. While there is no right or wrong way to do this, some techniques are more effective than others, just as some techniques are more effective in other investment methods.
This is kind of a “duh” statement, but important to understand: Trend following only works when there is a trend. Every investing technique has opportune moments in time to work, and this one is no different. When that surfer shows up at the beach and there are no waves—or worse, just little ripples—the surfer is going to have a tough day, wading in the water doing nothing. Poor waves are the worst, since the surfer will spend a lot of energy for little effect.
One argument against trend following is that you need to wait for a trend to actually exist before you identify it, so investors miss a lot of the move before they actually enter the trade. The worst are very short-term trends. Little “ripples” create havoc for a simple strategy. As the market starts rising, investors may identify the trend and then enter when the market reverses. They exit when the trend has broken, buying high and selling low, taking a loss when the general market might have been flat. Trendless time periods can dramatically affect performance in this investing strategy, though a more sophisticated system is robust enough to minimize the impact.
Because investors in this strategy are not predicting the future, they will never enter at the absolute bottom or exit at the absolute top. The goal is to catch the bulk of the trend (our personal goal is to catch 90% of the move up and miss 90% of the move down).
The Trend Is Your Friend
The beauty of trend following is that it doesn’t require you to suffer through large drawdowns, which is the primary reason it makes so much sense to the average investor. It’s not about capturing profit so much as the strategy’s uncanny ability to control risk and preserve capital.
To me, it’s to be used as a safety measure. It is about keeping our client funds safe in extreme times. Let’s face it, risk control is why our clients hire us. They expect that we will be there in volatile times to protect them. The market corrects on average two to three times a year, with sharp corrections of 20% or more every two to three years. Protecting our clients’ base is a very clear goal in these cases.
By not taking part in the declines, we have been able to outperform the market with a 153% return against the S&P 500, returning 8% over the past five years. So while a buy-and-hold strategy has been steadily chugging along to get a client back to breakeven, a trend following strategy missed the large drop and since then has been taking part in the gains.