Trend-Following for the Masses

BY ADAM BUTLER


For natural reasons, many novice investors and advisors try to harness the power of trend following to trade their favorite equity index. But this misses the point. By trend-trading a single index investors are extremely vulnerable to the probability of choosing an equity market with low forward returns, unproductive trends, or both.


In his 1998 second edition of “Stocks for the Long Run”, Jeremy Siegel added a chapter called “Technical Analysis and Investing with the Trend”, where he explored simple trend rules to time the U.S. stock market. In the chapter, Dr. Siegel revealed that the simple trend following strategy produced similar returns to a strategy of buying the index and re-investing dividends over the very long run, but with less portfolio volatility and smaller maximum peak-to-trough losses.

To this day, many novice investors and advisors make use of simple trend rules to try to time exposure to stock markets. The 200-day moving average that Dr. Siegel explored (and many other market timers and trend traders have been using for decades) is perhaps the most closely watched indicator. With the introduction of liquid ETFs tracking major equity indexes, it’s a simple matter for any investor to own stocks when the major indexes trade above this simple moving average, but cut and run when they break.

While novice investors typically stumble onto the concept of trend-following in the context of stock-market timing, professionals know that trend-following is not about using trends to time one or two individual markets. Modern professional trend-followers often trade dozens of futures markets across equities, bonds, currencies, commodities, and more obscure markets like carbon offsets.

In fact, professionals have long understood that the key to success with trend following, which most novice investors overlook, is diversification. In the preface to Michael Covel’s classic book, “Trend-Following”, Larry Hite, one of the original “Market Wizards” offered this story about the importance of diversification in trend-following:

In my early days, there was only one guy I knew who seemed to have a winning track-record year after year. This fellow’s name was Jack Boyd. Jack was also the only guy I knew who traded lots of different markets. If you followed any one of Jack’s trades, you never really knew how you were going to do. But, if you were like me and actually counted all of his trades, you would have made about 20 percent a year. So, that got me more than a little curious about the idea of trading futures markets “across the board.” Although each individual market seemed risky, when you put them together, they tended to balance each other out and you were left with a nice return with less volatility.

 

Larry’s insight was that the only way to achieve consistent results is to trade markets “across the board”. At the time, Larry was referring to the Chicago Board of Trade, which housed trading for most major commodity futures. Now futures are traded on a wide variety of exchanges, and investors are no longer constrained to trading commodity futures. But the same lesson holds today as it did four decades ago when Larry Hite began his trading career. That is, if you trade just one market “you never really know how you are going to do”, but if you trade markets across the board, you have a good chance of earning “a nice return with less volatility”.

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