The diagram shows a typical trend following model. Read further to understand the characteristics of trend following as an investing strategy:
Contrarian market psychology
The masses have often proven themselves wrong. Many so-called investors have short term price memory such that when they see a stock drop in price, they will think it is ‘cheap’ to buy. But more often than not, this ‘cheap’ stock would continuingly drop further in price! Trend followers on the other hand, would only buy a stock when it proves that it has the momentum to go higher, usually when the stock breaks new high and while the Majority thinks it is too ‘expensive’. The Majority only knows how to buy a stock up in price to gain profit, but not know how to profit from a stock’s drop in price. Trend followers practise shorting of stocks, which allow them to ride the trend even during a market’s poor run.
Emotionless, mechanical and automatic system
Humans have emotions even when they are investing. Trend followers believe emotions are detrimental to investing. Majority of the investors usually hold onto losing stock and ‘hoping’ that the stock will regain its value, and tend to sell off their stock early for a small profit as they ‘fear’ they may lose the profit. Thus, in order to removed such negative emotions, trend followers have a system of rules to instruct them when to enter and exit the market. In addition, they would have a computerised system with their technical analysis algorithms installed to filter out stocks based on their rules. They want to detach themselves from the stocks – “Do not fall in love with a stock” or “get married to a position” – and this is one of the most difficult challenges.
Pre-determine entry and exit points, and allowing profits to run cutting losses
Majority of the investors get in the market without knowing when to get out. This would allow emotions to take hold of their decision-making process as the market moves. They would then tend to hold on to losses and take profits too early. Trend followers know what price they shall enter and exit the market. They would cut loss when the market has proven them wrong and let the profits run when they are right. The ability to detach their emotions has allowed them to cut loss without thinking twice. This is vital to their survival as they know they cannot be right all the time and they need to minimize their losses – Live today in order to fight another day. By allowing profits to run, over the long run, these large profits will be able to offset the small losses to achieve capital gain.
Price is the main indicator – employment of technical indicators while company fundamentals carry little importance
Trend followers believe price of a stock provides the most clues than anything else. Price suggests trends and they are to follow these trends – Do not fight the trend. Many times, they buy stocks without even knowing what businesses are these companies into, lest to say analysing their fundamentals in annual reports. They would employ technical indicators like moving averages to assist in identifying stocks to buy. Usually, each trend follower will have his/her own selection of a few technical indicators to form a trading system.
Short term and no buy-and-hold
In a bull market, there will be mini-bear periods and vice versa. Thus, a price trend does not last very long – the longest being several months. Trend followers are considered short term investors because they exit trade once the trend reverses. They do not believe in holding on to losses or investing for the long term.
Sounds like gambling and cruelty of a zero-sum game
It may sounds like trend following is gambling but unlike the latter, it does not make predictions. It basically uses indicators and rules to determine the trend and follow it. Gambling depends on pure luck but trend following depends on the accuracy of the trading system and mastery of personal psychology to increase their probability of winning in the market. This means that for a trend follower to win, someone has to lose. On the other hand, it looks more ethical for a buy-and-hold investor to invest in sound businesses to improve economy and at the same time, receive capital gain for his/her investment. However, we need to remember for a company to succeed and increase in profits, its rivals and other industries have to take lesser profits or even go out of business. It is a zero-sum game too, just that it does not seem so direct.
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