The Trouble With Trend Following
“I would rather lose half of our clients than half of our clients’ money.”
– Jean Marie Eveillard, First Eagle Funds
No investment strategy is perfect. But you already knew that. That’s why today I want to tell you about the trouble with trend following…
Up to now, I’ve been telling you about the virtues of trend following. I showed you just how lucrative trend following can be with an example profit chart (and why it beats buy-and-hold investing), and I showed you how little work it takes to be a profitable trend trader — less than five minutes of “work” a day.
But I don’t want you to think that this strategy is without any downside at all. You need the whole picture if you’re going to be a successful trend follower.
So what do you need to know?
1. Timing Is Everything
It’s true — timing is everything. By that, I mean that when you start a new trend following system has everything to do with how you feel about it. Think about it this way: As a trend follower, your system makes money by jumping on big trends in the market. But what if there aren’t any big trends to take advantage of for a given week or month?
It takes time to get a true picture of how well a trend following approach is going to work. That’s exactly why we run long-term performance backtests before ever putting a single dollar on the line — we’ve got to be comfortable that our system beats the market and reduces risk, and that it has a high probability of continuing to do so in the future.
A couple of years ago, I was at a trading conference in Las Vegas where one of the speakers was trend following expert Michael Covel. After his talk, an attendee stood up and asked, “I’ve had money in a trend following system for a little while now and it hasn’t produced the results I’d hoped for. What do you recommend I do?”
Covel’s answer was simple: “Wait.”
You see, it was 2010 and the markets were slugging along sideways after making a huge move down in 2008 and a huge move up in 2009. Most trend following systems made plenty of gains both those years (yes, 2008 was a good year for most trend followers), but they didn’t during the lateral price action in 2010. Folks who jumped on the system then would have a pretty bad representation of how well it worked.
For trend following to really shine, you’ve got to give it time to sniff out the big trends.
2. You’re Going to Lose — A Lot…
Nobody likes to lose. But if you’re a trend following trader, you’d better get used to it.
It’s not uncommon for trend followers to have more losing trades than winners. I hinted at that last week. In the profit chart example I shared, our system had profits only about a third of the time, but it made huge gains over time. That works because the big trends that you hit a third of the time more than make up for the tiny losses you’re taking two-thirds of the time.
For that reason, it takes a little bit more mental toughness to be a trend follower. You’ve got to be willing to sell a few losers before you sell a big winner. But the beauty of this approach is that your system will tell you what names to buy and sell without any emotion involved. So as long as you can keep your long-term perspective, you’ll end up on top.
When you think about trend following logically, that makes sense. You’re looking to get in early on big trends, right? It follows that there will be times when the start of a new trend reverses and turns out to just be more sideways price action. A good trend system will tell you to sell those losers early enough that they won’t matter.
3. You Won’t Be “Right”
Investors like a story. You probably have a friend or neighbor who loves a certain stock. Every time you see him, it’s a good bet that he’s going to let you know how much money he’s making on shares of XYZ (or if it’s down, it’s a good bet he won’t bring it up at all).
That’s because investors like being right — it’s only natural to want to tell the world about your favorite investment and then get credit when it does exactly what you’d hoped. Who doesn’t want that ego boost? But as a trend follower, you won’t get to be right about investments anymore.
Instead, chances are that you won’t care what XYZ does. Instead, you’ll just care about the system you use.
Yes, that does mean that you’ll be short on stock stories around the watering hole at work or on the green with your golf buddies — but who cares?
Professional investors have a saying: There’s a difference between being right and making money.
There have been plenty of investors who were right about a major market event but were positioned poorly enough to lose money anyway. Ultimately, you can’t retire on “being right.” Trend following gives you the tools you need to make money. If you want the ego boost, stick to fishing.
Happy trading,
Jonas Elmerraji, CMT
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Jonas Elmerraji
Jonas Elmerraji, CMT, is the co-editor of STORM Signals and Penny Stock Fortunes, and a contributor to Agora Financial’s Trend Playbook. Jonas got his start on the fundamental side of the market, poring over financial statements and valuations to find sound investments – today, he specializes in blending fundamental and technical analysis. Jonas is a senior contributor to TheStreet.com, and has been featured as an investment expert in Forbes, Investors Business Daily, and CNBC.com among others.
Jonas holds a degree in financial economics from UMBC and the Chartered Market Technician designation.
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