Trend following investing, as described by AQR (a leader in alternative strategy investing) in an article, A Century of Evidence on Trend-Following Investing, is “going long markets that have been rising and going short markets that have been falling, betting that those trends continue.” In a nutshell, trend following investing tries to take advantage of moves in the markets by following these moves using a defined strategy. (For related reading, see: Behavioral Finance: How Bias Can Hurt Investing.)
Here are some trend following examples:
- The portfolio is fully invested at all times in either 100% stocks or 100% bonds.
- Every month compare the returns of the previous month for stocks and bonds.
- Invest in whichever assets (stocks or bonds) have had the greatest return.
- If the same assets (stocks or bonds) as in the prior month have the greatest return, do nothing, or else sell all and buy other assets that had the greatest return.
How Trend Trading Works
Investors recognize the up and down nature of investments over time, and most investors have experienced the loss of profits while holding an investment too long—once the trend had ended. Trend following hopes to minimize this by determining when a trend is changing.
Much of today’s trend investing relies heavily on math and complex algorithms with a multitude of inputs. Creating a trend following system requires the right algorithms with the right variables, time frame, formulas, investment universe, etc. The process of researching, creating, back testing and optimizing until you have a workable model requires a considerable amount of time and energy. In many cases, it can take months or years to create a model that might be profitable.
Why Bother With Such a Strategy?
The answer is explained in depth by AQR, which illustrates that a simple trend following strategy has not only shown positive returns during the past 10 years, but for the last 100 years. It is amazing that a strategy has been so consistent through not only the most recent financial crisis of 2008, but also through the Great Depression and multiple wars and other recessions. Creating a strategy that can be successful over so many different markets is the Holy Grail of investing. Pioneers in trend following investing, such as Jim Simons of Renaissance Technologies, have shown that you can consistently beat the market over the long term by using quantitative analysis.
What investor doesn’t want a strategy that can successfully provide positive returns for the next 100 years? Thousands of quants across the world are working on their algorithms hoping to fine tune them to create their own Holy Grail.
With billions of dollars being invested in trend following strategies, these models are in high demand by investors, hedge funds, mutual funds, and trading desks who will pay top dollar for a process that can produce the results they are looking for. (For related reading, see: The Financial Markets: When Fear and Greed Take Over.)
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