Over the past couple weeks, I’ve revealed how I’ve helped my clients consistently beat the S&P 500 by a wide margin: By strictly adhering to a mechanical trend following trading model.
But many of you have written in to ask how exactly that model works. Today, I’ll try to answer that question, and explain why I favor this system over other methods.
Investors vs. Trend Followers
Those who use the stock market to grow their assets have two choices. They can either be investors or trend followers. Investors generally follow a “buy and hold” strategy — they’re in it for the long term. Trend followers, on the other hand, try to use the ups and downs inherent in free markets to profit.
If you choose to go the buy and hold route, there’s a lot you’ll have to worry about. For example, are you buying too high? And when you’re ready to retire, will you be forced to sell too low?
These are not just hypothetical questions, as many investors who retired during the first decade of this century found out the hard way. Just consider the plight of aggressive buy-and-holders who invested in Nasdaq stocks during the 1990s.
By 2002, they had lost 70 to 80 percent of their capital. And if they continued to hold their shares through the recovery over the next five years, they then had to contend with the bear market of 2008-2009, which cut many stocks’ value in half again. Even cautious investors who focused on S&P 500 stocks would have emerged from the last decade in no better shape than they started.
Conversely, trend followers are not hostages to the whims of market forces. They use those forces to protect themselves against large losses, and position themselves to make big profits from long-term trends.
Two Kinds of Trend Followers
If you decide on a trend following strategy, you still have a decision to make: Whether to use a discretionary system, or a mechanical one.
Discretionary trend followers depend on the sum total of their market knowledge to make decisions. They may rely on their own market analysis, any number of technical indicators, gut feeling, current events, the anticipation of future news events, hot tips, etc.
Discretionary trend followers may change their minds, or second guess themselves. In other words, they’re subjective, so there are no guarantees that the trades they make are based on reality, and not colored by personal bias.
Mechanical trend followers, on the other hand, use timing strategies based on an objective and automated set of rules, to avoid the emotional biases that inevitably influence discretionary trading decisions.
|Mechanical trading takes the emotion out of investing.|
Mechanical trend followers adhere to a set of rules to get them into, and out of, the markets. They know that some trades will not be successful. But they also know that they will always be able to take advantage of the major trends. Trading on those trends, absent of any emotional bias, is what allows this type of investor to consistently outperform their competitors over time.
It should be obvious by now that I favor a mechanical trend following system to make my trading decisions. But what specific indicators is my model based on?
Mechanical Strategies Are Based on Price
The answer is simple: Mechanical trend following strategies are based on price.
That’s right. I look at one, and only one, number, because it is the only metric that is absolutely correct at all times. Other measures of a stock’s value can be misleading or manipulated. But price incorporates all the news, all the fundamental analysis, anything that may conceivably affect the company’s future.
This strategy may seem a bit boring to you. But I’m not really concerned about the fun or the emotional highs that many traders thrive on. No, I only care about one thing: Making Money.
And I’ve determined over many years of investing that the best way to make money — the best way to win — is by taking emotion and subjectivity out of the equation, and by using a simple, objective mechanical trend following strategy.
Learning to Ignore the Emotional Crowd
Stock market veterans understand that its movements aren’t based on the underlying fundamentals. They’re based on the decisions of millions of individual investors. And those investors’ decisions are usually driven by two overriding emotions: Greed and Fear. That is why volume spikes near the tops of rallies, and again near the bottoms of corrections. Greed causes investors to jump on board, and fear causes them to jump off.
The important lesson that all successful investors eventually learn is that while there may be comfort in following the emotional crowd, there is seldom profit.
And if you want to take this lesson a step further, you can employ a mechanical timing strategy to use the emotional ups and downs of the market to make money.
Yes, discretionary trend followers sometimes have big winners. Toss a coin enough times and it will come up heads eventually. But the only certain way to be successful for the long haul in the markets is to follow a non-emotional trading strategy and to always stick to the plan.
There is no second guessing. There are no worries. And the strategy is a proven winner. We know that the markets are in trends most of the time. Rallies and corrections are going to happen. It’s impossible to predict those trends with certainty, but using a mechanical trend following strategy allows us to identify them once they start, and profit along the way.