Why Trend Following Isn’t that Useful Today

Good morning! Today Troy continues with the investing for beginners series. You can check the previous posts about What are stocks and how to value them, How does Currency Trading Work, How are Currencies Traded, Investing in Commodities, What Fundamentals Affect Commodity Prices, What are ETF’s, What are Options, How are Options’ Prices Structured, Investing for Beginners Part 2 – Different Investment Strategies, When does Buy and Hold not Work, An Unconventional Approach to Buy and Hold, An Unconventional Approach to Buy and Hold Part 2, How the Investment Advisor Game is Played, An Introduction Into “Secular Investing”, Don’t Short When it Comes to Secular Investing, An Introduction into Trend Following, An Introduction into Technical Indicators, When does Trend Following Not Work, Risk Management for Trend Followers

In the past few posts I covered the basics of trend following and the critical flaw of trend following. That being said, I’d like to tell you a little bit about the history of trend following.

When Did Trend Following Work Well

Trend following started in the late 1960s and early 1970s. It was originally used by commodity traders and investors in the commodity markets (oil, gold, silver, copper, etc) because the 1970s saw a massive secular bull market in commodities. That being said, it is obvious that trend following doesn’t work too well in a secular bear market because overall, a secular bear market means that the market merely whipsaws instead of trends.

Trend following was initially very profitable in the 1970s and 1980s – the biggest traders of the day were all trend followers. This includes the likes of Paul Tudor Jones, Bruce Kovner, Richard Denise – all hotshots in the 1970s and 1980s.

Seeing the massive profits made with trend following, many investors and traders naturally became trend followers. With legions of new trend followers in the 1990s, the profitability of trend following started to deteriorate. By the early 2000s, trend following wasn’t that profitable at all because too many people started using it. So what changed? Why are no present day mega-successful investors and traders using trend following as their primary investment strategy?

What Changed

The nature of the stock, commodity, and currency markets changed. Prior to the 1970s, working on Wall Street or any career related to investing/trading was seen as unfashionable. Having an economics major back in the day was about as unfashionable as having an art history degree today (sorry to pick on y’all art history majors out there).

With virtually no competition out there, investing was actually pretty easy back in the 1970s (which was also somewhat true in the 1980s) compared to today. If you understand the basic trend following concepts, you could have made excess returns of 20%. Why? Because investing is a zero sum game (one winner for every loser), and in the 1970s most of the “money managers” out there were terrible at their job. If everyone else is absolutely terrible, all you need to be is a little above average. Investment success is relative. With greater competition means that investing is (in absolute terms) much harder than it used to be.

But by the late 1980s and early 1990s, a lot of people started using trend following as a “smart” investment strategy. So what happened was that the whole investment community got a whole lot smarter, and trend following techniques went from the forefront of smart investing to standard practice among investors and traders. Thus, the distinct advantage that trend following once gave investors disappeared.

Trend Following Today

In the post 2008 Market Crash world, very few highly successful investors, traders, and fund managers still massively employ trend following techniques. Reality is, trend following often doesn’t work well like it used to. For example, traditional trend following said that if the market price rose above a moving average, it’s time to BUY because a new bullish uptrend is starting to form. But theses days, the markets will often criss-cross the moving averages many times in a year, yielding a whole bunch of useless BUY/SELL signals. With an increase in volatility (market fluctuations), trend following technical indicators (like in a whipsaw market) often generate exactly the wrong buy/sell signals at precisely the wrong time.

That being said, although trend following is no longer a superior investment strategy, it still is a above average strategy that will yield above average investment returns. In the following posts, I will discuss my preferred method of investing – contrarian investing. See y’all next time!