Trend following — It sounds so simple, doesn’t it? As Dennis Gartman of the Gartman Letter often likes to say: “If the chart is moving from the bottom left to the top right, then I like it.” And to the untrained eye, that’s all trend following is. It’s identifying a trend and riding it. And as the famous saying goes: “The trend is your friend . . . until it ends.” And that’s where trend following adds so much value. Trend following is not just about identifying great investments. It’s about using rules and techniques to manage the risks associated with these investments. What appears to be a very simple strategy at first glance is actually a sophisticated, multidimensional, and vital technique utilized by successful investors all over the world.
I should be clear that I am not a pure trend follower. I use a multi-strategy approach primarily due to my belief that no two market environments are ever the same and that markets are highly inefficient. What works in one bull market or bear market will not necessarily work in the next bull or bear market. This is why trading requires a great deal of flexibility and an ability to conform and adapt to new environments. At the core of my work are risk management and the establishment of a systematic approach. Trend following has been absolutely vital in helping me develop the foundation of my investment strategies.
When I graduated from college with a degree in finance I was your typical hungry young investor. But I was lost. And so I did what most investors do, and I began reading the works of those who had already succeeded in the business before me. I printed out every shareholder letter by Warren Buffett, and I read all of the standard books from A Random Walk Down Wall Street to One Up on Wall Street to The Intelligent Investor. And then one day my father gave me Michael Covel’s first book Trend Following. It didn’t look like anything fancy at first glance, but the powerful message conveyed in the book changed the way I viewed investing forever.
You see, trend following isn’t just drawing a line on a chart and hoping it continues from the bottom left to the top right. Trend following is about studying the history of market movements, creating a game plan, having rules, learning how to apply those rules, understanding money management, and utilizing a risk management approach. It isn’t about using all the failed techniques that the Wall Street establishment has sold to the small investor for so long. Trend following is about thinking outside the box and understanding that the techniques of trend followers are applicable to all markets and all trading strategies. You don’t have to agree with the strictly technical analysis aspect of trend following to know that the techniques applied by trend followers are absolutely vital components of any good investor’s success story.
One of the more important aspects of trend following is that its users understand the importance of psychology in markets. I like to say that a market is the summation of the decisions of its participants. Markets are inefficient because the participants are inefficient. Thus, the participant with superior emotional control has a decisive advantage. As Michael says:
Trend trading is not a holy grail. It is not some passing fad or hyped-up secret black box, either. Beyond the mere rules, the human element is core to the strategy. It takes discipline and emotional control to stick with trend trading through the inevitable market ups and downs. Keep in mind, though, that trend followers expect ups and downs. They are planned for in advance.
This irrationality was on full display in 2008. At the beginning of 2008, before one of the greatest periods of wealth destruction that the world has ever seen, the average Wall Street analyst had a “sell” rating on just 5 percent of the stocks covered, and recommended a “buy” or “hold” on the other 95 percent. Wall Street doesn’t prepare you to understand when to sell. You see, Wall Street is always thinking of new ways to get you to buy or hold its new products. If you’re a car salesman, it’s difficult to make money if you tell everyone who walks onto the lot that they shouldn’t buy. Trend following closes the loop by not only helping you decipher the right times to buy, but also helping you to manage risks, develop a systematic approach, and identify when to sell. And the results speak for themselves. While the average U.S. equity investor lost 50 percent of his or her money, trend followers crushed the Standard & Poor’s 500 in 2008 because they had pre-established risk management structures in their portfolios.
According to an ancient proverb, “failure to plan is planning for failure.” Trend followers succeed because they have implemented an investment approach that focuses on risk management and strict adherence to rules. And whereas you don’t need to be a trend follower to succeed in the investment world, you certainly need to understand the importance of risk management, the establishment of rules, and planning in advance. If not, you are destined to fail. Michael’s The Little Book of Trading is a must-read guide to help you succeed in the shark-infested waters of the investment world.
Cullen O. Roche
Founder and CEO, Orsus Investments, LLC
Proprietor of Pragmatic Capitalism