What is Trend Following?: A Beginner's Guide

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Trend following is an investment strategy that capitalizes on the momentum of market trends. It's a straightforward yet powerful approach used by many successful investors. In this article, we'll break down what trend following is, the key principles behind it, why it can be a good investment choice, how to choose a trend following manager, and the advantages and disadvantages of this strategy.

What is Trend Following?

Trend following is an investment strategy that aims to profit from the continuation of existing market trends. The idea is simple: if a market is trending in a particular direction (up or down), it is likely to continue in that direction for some time. By identifying and following these trends, investors hope to ride the wave and make profits as the trend persists.

Key Principles of Trend Following

Price Action is Key: Trend followers rely on price movements rather than fundamental analysis. They believe that all available information is already reflected in the price.

Let Profits Run: Once a trend is identified, trend followers hold onto their positions as long as the trend continues. The goal is to maximize gains by staying in the trend for as long as possible.

Cut Losses Short: Trend followers have strict risk management rules. They may set stop-loss orders to exit positions that move against them quickly, minimizing potential losses.

Diversification: Trend followers often diversify across different markets and asset classes to spread risk and increase the chances of catching trends.

Mechanical Systems: Many trend followers use systematic trading strategies based on predetermined rules, removing emotional decision-making.

Why Invest in Trend Following?

Profit from Market Movements: Trend following allows investors to capitalize on significant market moves, whether in stocks, bonds, commodities, or currencies.

Non-Correlated Returns: Trend following can perform well in different market conditions, providing diversification benefits to a traditional investment portfolio.

Historical Success: Trend following has a long track record of success, with many notable managers employing this strategy effectively.

How to Pick a Trend Following Manager

Track Record: Look for managers with a proven history of success in trend following. Successful long-term performance over different market cycles is a good indicator of skill, even if the monthly returns can be volatile.

Risk Management: Assess the manager's approach to risk management. Effective trend followers should have clear strategies for cutting losses and protecting capital.

Transparency: Choose managers who are transparent about their strategies and performance. This includes regular reporting and clear communication.

Fees and Costs: Understand the fee structure. It’s important that there is a fair balance between a management and performance fee.

Advantages of Trend Following

Simplicity: The strategy is based on clear and simple rules, making it accessible to many investors.

Adaptability: Trend following can be applied across various markets and asset classes, offering flexibility.

Risk Management: The emphasis on cutting losses helps protect capital and manage risk effectively.

Disadvantages of Trend Following

Whipsaws: Markets can experience short-term fluctuations that trigger false signals, leading to small losses that may build to meaningful drawdowns, known as whipsaws.

Reversals: If a number of markets and sectors experience rapid reversals of their current long-term trends, this can lead to sharp and meaningful losses for trend following strategies…but this is completely natural.

Requires Discipline: Sticking to the strategy requires discipline, especially during periods of sideways or choppy markets.

Potential for High Costs: Frequent trading can lead to higher transaction costs, which can eat into profits, unless managers are able to negotiate competitive brokerage fees.

Conclusion

Trend following is a time-tested investment strategy that leverages market momentum to generate profits. By understanding its key principles, recognizing why it can be a valuable addition to your investment portfolio, and knowing how to choose a competent trend following manager, you can make informed decisions about incorporating this approach into your investment strategy. Like any investment method, it has its pros and cons, but with the right mindset and discipline, trend following can be a powerful tool in any investor's arsenal.

For more information about trend following, check out the free eBook “Ten Reasons to Add Trend Following to Your Portfolio” which gives an in-depth explanation of the benefits of this robust strategy.

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