Trend Following: Don’t Think, Just Buy!
I’ll bet you never thought someone would tell you “Don’t think, just buy” was good investment advice. But in a moment, I’ll show you why it is…
Today, I want to clear up some misconceptions about how to build generational wealth as a trend follower. Here is a question I received from a reader:
“What is the trend-following system you are using, as I couldn’t see a particular article since I subscribed about how to use this?”
It may sound surprising, but historically, simple is better for trend-following strategies. The foundation of our system is a 300-day moving average. I introduced it back in September (you can read the full write-up here).
Why the 300-day moving average?
A moving average is a stellar indicator of trend — if it’s moving steadily higher, then we know that a stock is generally moving higher over the time period that we’ve set. At 300-days, the MA is long-term enough to catch only big primary market trends. Most importantly, we can define moving averages mathematically, so we’ve got a completely unambiguous signal that a stock is trending higher if it moves above the moving average.
The system has a few extra tweaks and rules added to boost its profitability, but the 300-day moving average is the foundation.
Not everyone is a fan of my time frame, though. Like this reader:
“Are you joking with a 300-day MA? When I apply it to my [S&P 500] chart there are no trades! If I use a 200-day [moving average], then the only buy signals would have been on Nov. 19, 2012 and Dec. 28, 2012. So what does one do after missing those signals? Read a book?
“Come on, now. There must be signals that occur each day or so?”
He’s right. This sort of a trend-following strategy doesn’t generate a whole lot of signals…
But that’s kind of the point.
For starters, you don’t want to apply this system to just one market — it works best when you use it to find that primary trend in a basket of low-correlation asset classes. And frankly, I wouldn’t trade every signal that the system threw out; I’ve found the best success rebalancing once a month. That’s it.
In fact, already I showed you how upping your trading frequency can destroy your returns.
When you’re using a “slow” moving average (like the 300-day) to generate signals, you also want to use a slow trading frequency. You can’t mismatch the two.
Of course, you could always use a faster signal to get weekly or even daily signals. But the question is whether you’d want to. By just making your one trade a month with our slow system, you could have made some enormous gains with tiny risk. That’s in part because the underlying primary trends in global markets are slow too.
In other words: If you can earn 80% of the gains trading only 20% of the time, why wouldn’t you?
If you want to ramp up your potential returns (and risk), add some more volatile assets to your radar (like futures). And when you’re waiting on a trading signal, sure, read a book. I recommend this one…
This last question is an important one. It comes after last week’s update from our system said we should own stocks:
“Yikes, I just took profits in my equity funds and put my money in a commodity index because I felt like it was giving me a buy signal and stocks are getting frothy like a blowoff. Let me know if I should reverse my decision or if I am OK, just a bit early.”
It’s easy to overthink the signals that get thrown out by a trend-following system. I certainly have my own analysis on where the stock market is headed in 2013 — but as far as my trend-following portfolio is concerned, it doesn’t matter one bit.
When you’re using a trend-following approach, don’t think, just buy. (See, I told you we’d get back to that!)
It’s important not to overanalyze your trading signals. The heavy analysis comes into play when you’re developing your system, not when you’re trading it. If the statistics and back testing indicate that your system works, then that’s when you take your hands off and start listening.
By its nature, a trend-following approach is going to spit out trading signals that you won’t want to follow from an emotional standpoint. If you want to be successful, it’s critical to blindly follow the system…
Jonas Elmerraji, CMT
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