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Please don’t allocate to Trend Following

Please don’t allocate to Trend Following

What is Trend Following? Beyond the technical bits and pieces – like the all-important entries, exists, stops, position scaling rules, time frames, traded markets etc. – Trend Following is a reflection of a philosophical understanding of the world and financial markets. Let’s investigate.

Trend Followers believe that diversification is the only free lunch in finance or as Ray Dalio calls it “The Holy Grail of Investing” and so they strive to produce strategies with as many independent bets as possible.

Trend Followers are aware of the struggles and mental discomfort the human psyche experiences when faced with financial losses, and the tendency to take emotional decisions at the worst possible moment. It is for this reason that Trend Followers advocate and implement a robust, systematic and rules-based approach that protects them from these behavioural biases.

Trend Followers are also aware of the limitations of human nature and knowledge. They don’t try to forecast where asset prices will go as it’s their belief that the future is not predictable.
Putting this philosophy into practice, combined with the power of using rules and automation leads you to Trend Following - a trading strategy that not only has a positive expected long-term return expectation but also little to no correlation to traditional asset classes like equities and bonds.

The importance of the latter can hardly be overstated, especially within a broader portfolio context. You can add as much regional and industry diversification to your equity portfolio as you want, but when markets tank you can be sure your positions will go down in synchrony. You can attempt to diversify your equity risk by investing in bonds. However, unless you stick to U.S. Treasuries, German bunds, or Japanese govies, and instead invest in anything with a hint of embedded credit risk, you can be sure you are getting much less diversification that you would expect.

Oh, and by the way…the long-term correlation between bonds and stocks is in fact positive…that means that most of the time they go up and down together!

Trend Following is therefore one of the few strategies out there that has the potential to enhance your portfolio returns and materially diversify your existing long-only portfolio (due to its lack of correlation to traditional asset classes), and thus reduce the overall risk and drawdown of your portfolio. As a return stream to add to your portfolio, there is hardly anything better than Trend Following out there.

This is not our opinion by the way…this is what ALL the evidence confirms.

But Trend Following is not for everyone. Yes, that is right. Some investors should not invest in this strategy.

For example, if you think you can predict the “trendiness” of a particular market environment or sector and attempt to time your exposure to Trend Following…please don’t bother. Or if you think, buy High and selling Low is a bad idea…because value investing does the opposite…then you should refrain from investing in this strategy.

We would even encourage investors who fail to appreciate that adding an uncorrelated return stream can reduce portfolio volatility and the risk of negative outliers to please stay away from Trend Following. You won’t enjoy the ride and you are going to get in at the high and out at the low of a drawdown.

To all other investors – we are happy to welcome likeminded investors like you on our side of the fence. We are pretty sure you are going to like what you find, and the people involved in this part of the investment industry.

We would also suggest you tune into this week’s episode of the Systematic Investor series with Alan Dunne who touched upon many exciting topics including the issue described above.

As usual, we promise your time will be well spent!