April 22, 2016

How ‘trendy’ is your investment strategy?

We all want to understand and profit from the latest trends, particularly when it comes to investment opportunities and strategies - but is it worthwhile jumping on the bandwagon? Here we explore the upsides and downsides of investing for or against market trends.

We all want to understand the latest trends, particularly when it comes to investment opportunities and strategies – but is it worthwhile jumping on the bandwagon?

Trend-following is an investment strategy that aims to profit from trends or momentum in security, currency or commodity prices.

So what is a trend follower in investment strategy terms? Trend-followers use technical analysis, charts or computer models to try to identify short or long term price trends, either upwards or downwards.

Trend following behaviours

The following behaviours are typical of a trend follower, they:

  • don’t use any form of fundamental analysis to determine whether a security, currency or commodity is cheap or expensive,
  • aim to find prices that appear to be moving in a certain direction and “jump on for the ride”,
  • generally use a systematic, rules based approach to investing i.e. they create a set of rules that determines when to enter the market, how much to invest, when to exit the market if the trend continues or if the trend reverses,
  • usually categorised based on their investment time horizon: short term trend followers invest in trends that last for days, whereas longer term trend followers can invest for many months.

Tips on Trend-Following

Systematic trend-followers typically churn their portfolios frequently, and as a result can incur significant transaction costs. They also need to ensure that the portfolio is diversified so that if the expected trend does not eventuate, or quickly reverses direction, any losses are limited. Trend-following models will typically include stop-loss rules to limit any losses if the trend does not continue once the investment is made.

Considerations for adopting a trend-following strategy

Trend-following strategies tend to work best when markets are rising or falling in a smooth manner, for example, markets trended lower in 2008 which rewarded trend following strategies. Choppy markets that rise and fall without strong moves in either direction tend to hurt trend following strategies.

For this reason, many people consider these strategies similar to owning a basket of both call and put options; if markets move strongly in either direction, the options will pay off, but if markets don’t move much, the investor will lose their option premiums.

Because trend-following strategies can perform well in falling markets and can profit from movements in currencies, indices, futures contracts and commodities they can sometimes be a useful tool to diversify a traditional share and bond portfolio.

Large trend-following fund management firms typically employ significant computing power to analyse thousands of market prices searching for trends, which can then be acted upon quickly.

Is past performance indicative of future performance?

Critics of trend-following strategies argue that they require a belief that past performance is an indicator of future performance and that it is not possible to develop computer trading models and investment rules that can consistently generate investment returns in all types of market conditions.

Tactical Trend Following – currency trends

An example of a simple trend-following strategy could be to buy US dollars when the 30-day moving average price crosses above the 200-day moving average price, indicating that the trend has turned upwards. See chart below.

Currency - Australian Dollar Exchange Rate Trend Following v3