Trend Following

Trend Following is an investment or trading strategy that seeks to profit by analyzing and capitalizing on an asset's price momentum in a particular direction. The core belief is summed up by the old market adage, “the trend is your friend.” Practitioners don't try to predict market tops or bottoms; instead, they wait for a trend to establish itself and then ride it for as long as it lasts. This approach is a cornerstone of `Technical Analysis`, as it relies exclusively on market price data rather than `Fundamental Analysis` of a company's business. Trend followers buy assets that are rising and sell (or `Short Sell`) assets that are falling. This reactive strategy is often systematic and automated, executed by quantitative funds and professional `Commodity Trading Advisors` (CTAs), particularly in the `Futures` markets. While it shares similarities with `Momentum` investing, trend following typically focuses on longer-term price movements and is defined by its strict, rules-based entry and exit points.

At its heart, trend following is a beautifully simple, albeit challenging, discipline. It operates on the premise that strong market movements, up or down, are more likely to continue than to reverse. A trend follower acts like a surfer, patiently waiting for a wave (a trend) to form, catching it, and riding it for as long as possible before it breaks.

A trend following system is not based on gut feelings or daily news. It is a strict, mechanical process built on a few key components:

• Price is Everything: The only piece of information that matters is the price. A trend follower doesn't care about a company's earnings, its management team, its `P/E Ratios`, or what analysts are saying. The market price is believed to incorporate all known information.
• Trend Identification: The system needs a clear, objective signal to identify when a trend has begun. This is often done using technical indicators. A classic example is the `Moving Average` crossover. For instance, a system might generate a buy signal when the faster 50-day moving average crosses above the slower 200-day moving average, indicating a new uptrend. Another popular method is a `Channel Breakout`, where a buy signal is triggered when the price hits a new high for a specific period (e.g., a 52-week high).
• Strict Entry and Exit Rules: Decisions are automatic. If the system signals “buy,” the trader buys. If it signals “sell,” the trader sells. There is no second-guessing. This discipline is designed to remove emotion—fear and greed—from the equation.
• Ironclad Risk Management: This is perhaps the most critical element. Since not all signals will lead to a profitable trend, the strategy's survival depends on managing losses. Trend followers live by the mantra: cut your losses short and let your profits run. They achieve this by using pre-determined `Stop-loss` orders, which automatically sell a position if it moves against them by a certain amount. This results in many small, manageable losses, which are hopefully offset by a few large, highly profitable winning trades.

For followers of `Value Investing`, the trend following philosophy stands in stark opposition to their core principles. The two approaches are, in many ways, looking at the market through opposite ends of a telescope.

The central conflict is between price and value.

• A value investor, in the tradition of `Benjamin Graham` and `Warren Buffett`, believes that the market price of a security can and often does diverge from its underlying `Intrinsic Value`. The goal is to buy assets for significantly less than they are worth, creating a `Margin of Safety`. This often means buying when an asset is unpopular and its price trend is negative.
• A trend follower believes the price is the ultimate reality and that its direction is the only thing that matters. They are, by definition, buying what is popular (rising in price) and selling what is unpopular (falling in price).

A value investor buys a stock like a grocer buys produce—they want to pay less for it than they know they can sell it for. A trend follower buys a stock like a spectator jumping on a bandwagon—they join the parade simply because it's moving.

From a value investing viewpoint, trend following has several significant drawbacks:

• Whipsaw Markets: The strategy performs terribly in markets that are trading sideways with no clear direction. In these ranging or “whipsaw” markets, the system generates a frustrating series of false signals: buying at a small peak only to be stopped out for a loss, then selling at a small trough just before the price recovers. This can lead to a slow and steady erosion of capital.
• Ignoring Absurdity: Because it ignores fundamentals, a trend following system can't distinguish between a solid company and a speculative bubble. It would have happily ridden a company like Pets.com all the way up during the `Dot-com Bubble`, only to follow it all the way back down to zero, taking losses along the way. A value investor asks “Why is this price moving?” A trend follower only asks “Is the price moving?”
• High Costs: The frequent trading inherent in trend following can lead to substantial transaction costs and higher tax bills (due to `Capital Gains` from short-term trades), which can be a significant drag on overall returns.

Trend following is a legitimate and, for some professionals, a highly successful strategy. Its unwavering focus on risk management is a lesson from which every investor can benefit. Cutting your losses decisively is a powerful habit. However, for the ordinary individual focused on building long-term wealth, it is a difficult and often counter-intuitive path. It requires the emotional fortitude to endure long periods of small losses and the discipline to stick to a rigid system even when it feels wrong. The `Value Investing` approach offers a more intuitive and, we believe, a more robust framework. By focusing on buying wonderful businesses at fair prices—and holding them for the long term—you are investing in the tangible value created by a business, not just betting on the fickle direction of its price chart. It is a strategy grounded in business reality, not just market psychology.