If there’s one thing I’ve learned throughout my decades of investing, it’s that the markets can, and usually will, throw you curveballs. You’ll also probably have to deal with fastballs, sliders, splitters, changeups, and knuckleballs.
If you want to hit any of those pitches out of the park, you have to learn to turn the odds in your favor. That’s what trend followers, like me, do better than anyone.
Ignoring the Conventional Wisdom
When I was a stockbroker in the 1970s, the prevailing investing strategy taught by mutual fund companies and wire houses was “Buy and Hold.” That approach is fine and good if you’re willing to wait twenty or thirty years for your investment to pay off. But Buy and Hold can be a disastrous strategy over shorter time frames.
|A Buy and Hold strategy can be disastrous over short time frames.|
Just consider the poor saps who sunk most of their money into stocks before the crash of 2008. The S&P 500 and the Nasdaq Composite lost roughly half of their value, wiping out countless Buy and Hold investors.
Those investors learned the hard way that when they wade into the stock market, they’re playing in the Big Leagues. And make no mistake: Stock market investing is a zero-sum game — there are winners and there are losers.
The winners are the ones who understand the rules of the game, and the psychological battles that all investors face, and use them to their advantage.
Trend Following and the Psychology of Investing
Trend following strategies, like the one I developed with my friend and mentor, Sir John Templeton, are designed to take emotion and subjectivity out of the investment equation. It is only by taking an objective approach based on hard and fast rules that you can hope to cut losses short, and allow profits to ride on a consistent basis.
Trend followers understand better than most that many market trends are driven by the emotions of fear and greed. Fear causes many individual investors to jump out of their positions at the bottom of the market, compounding their errors. And greed causes them to jump in at the top of the market, ensuring losses ahead.
But by identifying those emotions, we trend followers take steps to protect ourselves. We do this by setting strict guidelines based simply on numbers and probability, and then following those guidelines without hesitation.
Trend Following and Probability
Everyone knows that if you toss a coin one hundred times, you can expect it to come up heads about fifty times and tails about fifty times. But if you only toss the coin ten times, it’s possible you’ll get ten heads, or ten tails.
The same concept can also apply to investing: All things being equal, half of your trades are likely to produce profits, while the other half will produce losses. But many inexperienced individual investors fail to understand the second part of the corollary. In other words, they get frustrated if they have ten losing trades in a row. They allow emotion to get the best of them.
Disciplined trend followers, on the other hand, expect losing trades, so we’re not disappointed when they happen. We have our eyes on the big picture, and we prepare ourselves mentally for the long haul.
We know that investing isn’t easy money, and we won’t become rich overnight. It’s that mindset that helps us stick with our trading strategy, and turns the odds in our favor over time.
The Trading Edge
Any investor who wishes to embark upon a trend following strategy needs to keep two important things in mind in order to have consistent success:
1. Probability — As I mentioned, if we flip a coin enough times, it will land heads up 50 percent of the time, and tails up 50 percent of the time. Trend followers have to keep flipping the coin, and cannot become frustrated by a string of losing trades.
2. Risk vs. Reward — Trend followers seek to establish that the potential rewards of a trade are greater than the risk of losses.
Trend followers achieve a “trading edge” by understanding that the stock market has been in a trend, either up or down, through about 80 percent of its history. That knowledge helps us time our entry and exit points.
In other words, we are able to determine which tosses of the coin will remain profitable for some time, and stay in those trades. On the other hand, we can ascertain quickly which tosses of the coin will be unprofitable, and exit those trades before taking too big a hit. As long as we make all the tosses, we know that we will win over time.
That last point is important: Nobody knows which trends will quickly reverse, and which will become the long-term trends that produce big profits. That’s why we have to make every trade that the systematic model recommends, without exception.
By faithfully following this strategy, we’re almost guaranteed to never miss a trend. And since the markets are in trends more often than not, we can potentially make larger profits from these trends, while at the same time minimizing losses from trend failures.
Unfortunately, we’ve experienced choppy, or trendless, markets for the past few months. But these are the times when it’s most important to understand the logic of the trend following strategy.
When new, long-term trends do begin, trend followers like us will be well-positioned to profit from them. Stay the course, make all the coin tosses, and over time, you win.