Our Approach: Trend Following

For all those investors and traders who wish they’d done things differently, now in need of an aha! moment.

It doesn’t matter that you think, it’s what the market does that matters.
You don’t need to know when something will happen to know that it will.
Successful trading is a probabilistic business, so accordingly.
Trading means losing as well as winning.

“Let’s break down the term ‘Trend Following’ into its components. The first part is ‘trend’ Every trader needs a trend to make money. If you think about it no matter what the technique, if there is not a trend after you buy, Then you will not able to sell at higher price…‘Following’ is the next part of the term. We use this word because trend followers always wait for the trend to shift first, then ‘Following’ it.”

Trend following seeks to capture the majority of a trend, up or down, for profit. It trades for profits in the major asset classes-stocks, bonds, currencies, and commodities. The discipline works across all classes enabling much more to be monitored and managed than a fundamental approach.

At the end of the nineties, just when you were feeling good about yourself because you were more secure financially, the dot-com bubble burst, and by the time it was over, you had lost a significant amount of money. You were angry with the analysts, experts, brokers, of money managers whose advice you had taken. Now you doubt that you will ever meet your investment goals. You’ve held on to your remaining investments believing that the market will eventually turn around, but deciding what to do with your money has become stressful. You still believe that buying at the bottom is the way to go.

There is a much better way to think about investing. How would you feel about embracing this perspective? The approach is objective and rational. A system that doesn’t just rise and fall with the market and is content to wait patiently until the opportunity comes along.

Most people think of themselves as investors. However, if you knew that big winners in the markets call themselves, traders, wouldn’t you want to know why? Simply put, they don’t invest, they trade.

Investors put their money, or capital, into a market, like stocks or real estate, under the assumption that the value increases, so does the person’s “investment”. Investors typically do not have a plan for when their investment value decreases. They hold on to their investment, hoping that the value will reverse itself and go back up. Investors typically succeed in bull markets and lose in bear markets.

This is because investors anticipate bear, or down, markets with fear and trepidation and therefore are unable to plan how to respond when they’re losing. They chose to “hang tight”, so they continue to lose. They have an idea that a different approach to losing involves more complicated trading transactions like “selling short” of which they know little and don’t care to learn. If the mainstream press continually positions investing as “good” or “ safe” and trading as “bad” or “risky”, people are reluctant to align themselves with traders or even seek to understand what trading as opposed to investing, is all about.

A trader has a defined plan or strategy to put capital into a market in order to achieve a single goal: profit. Traders don’t care what they own or what they sell as long as they end up with more money than they started out with. They are not investing in anything. They are trading. It is an important distinction. There is no need to always be in the market. A trend follower can wait weeks or months for a trend.

However this type of technical analysis neither predicts nor forecasts. This is based on price. Trend followers form the group of technical traders that use this type of analysis. Instead to predict a market direction, their strategy is to react to the market’s movements whenever they occur. Trend followers respond to what has happened rather than anticipation what will happen. They strive to keep their strategy based on statistically validated trading rules. This enables them to focus on the market and not get emotionally involved.

However, price analysis never allows trend followers to enter the exact bottom of a trend or exit at the exact top of the trend. Second, with price analysis they don’t have to trade every day. Instead, trend followers wait patiently for the right market conditions instead of forcing the market.

Technical Analysis. Practices a disciplines investment process.

‘Have the markets changed?’ I always tell them the truth: ‘Yes.’ Not only have they changed, but they will continue to change as they have throughout history and certainly throughout my 30 years. Trend Following presupposes change. It is based on change.

Market go up, and down, and sideways. They trend. They flow. They surprise. No one can forecast a trend’s beginning or end until it becomes a matter of record, just like the weather. However, if your trading strategy is designed to adapt to change, you can take advantage of the changes to make money: “If you have a valid basic philosophy, the fact that things change turns out to be a benefit. At least you can survive. At the very least, you will survive over the long term. But if you don’t have a valid basic philosophy, you won’t be successful because change will eventually kill you. We simply follow trends. No matter how ridiculous those trends appear to be the beginning, and no matter how extended or how irrational they seem at the end, we follow trend”.

Because decisions are ultimately based on one piece of core information: price. In an increasingly uncertain and, these days, downright unfriendly world, it is extremely efficient and effective if our decision-making is based on this signal, simple, reliable truth. The constant barrage of fundamental data, such as price-earnings ratios, crop reports, and economic studies, plays into traders’ tendencies to make trading more complicated than it needs to be. Yet, factoring in every possible fundamental still does not tell a trader how much and when to buy, or how much and when to sell.

Just think of all those traders who recommended Enron for the whole year it was going down before it eventually went bust. Or the pre GFC crash recommendations to buy,…the only thing worthwhile was following trends which reversed ..no need to know why you just need to they have.

Handing Losses

You are going to have ups and downs in your trading account. Losses are a part of the trading game. You’re going to have willing to lose losses with Trend Following: “You can’t make money if you are not willing to be lose. It’s like breathing in, but not being willing to breathe out”.

If you don’t have losses, you are not taking risks, If you don’t risk, you won’t win big. Losses aren’t the problem. It’s how you deal with them. Ignore losses with no plan and they will come back to haunt you. Trend Following works to handle loss with stops. This sensible approach allows you to continue to trade: “Theoretically, really big losses rarely befall a trend follower since he decides to eliminate or reserves his position as soon as the market goes against him. Losses are inevitable just make them small.

Then invest your funds with someone who possesses an objective track record and whose investment aims match your own.

No one knows how high or how low a market will go. No one knows when a market will move. You can’t undo the past, and you can’t predict the future. Prices, not traders, identify a trend – they do not predict the future
Trend followers buy high and sell low. This is counterintuitive for most people. But they do get you in at the start of an uptrend and out at the beginning of a downtrend.
Losses are a cost of doing business. No one can be right all the time. No one can make money all the time. Trend followers expect and handle losses with objectivity and detachment. If you don’t have losses, you are not taking risks. If you don’t risks, you won’t win.
Price must go either up, down, or sideways. No advances in technology, leaps of modern sciences, or radical shift in perception will alter this fact.

Trend followers have no desire to force some preconceived return. You can’t dial in a certain amount return for some given year. There are no profit targets that work.

"We stick to our knitting."
"Most people don’t have the discipline to do what they need to do."
"We like to keep it sophisticatedly simple."
"Our best trading days are when we don’t trade."
"We make more money the less we trade."
"Some of our best trades are when we are sitting on our hands doing nothing."
"We don’t want to be the smartest person in the market. Trying to be the smart person in the market is a losing game."

Long-term trend identification: Trading systems ignore short-term volatility in the attempt to capture superior returns during major trending markets. Trends can last as long as a few months or years.
Highly disciplined investment process: methodology is designed to keep discretionary decision-making to a minimum.
Risk management: Traders adhere to a strict formulaic risk management system that includes market exposure weightings, stop-loss provisions, and capital commitment guidelines that attempt to preserve capital during trendless or volatile periods.
Global diversification: By participating in more markets and not focusing on one country or region, have access to opportunities that less diversified firms may miss.

Trend followers don’t try to anticipate reversals or breakouts. They respond to them. Trend followers believe that markets are smarter than any of their individual participants. They understand that attending to what is taking place.

In the market from moment to moment isn’t a technique, it is what is and that is all. The moment, the here and now, is the only place that is truly measurable.

Have you ever said ‘the market’s wrong’, it’ll come back.’ The market is never wrong” Ask yourself if you want to win. They are different questions.

“Unfortunately, markets do not step to a drummer that we control. The period we have just been through has been terrifically painful for investor, brokers, general partner and trading advisors. Drawdowns affect everyone emotionally, psychologically and physically when they persist. It becomes very easy to envision a scenario in which things never get better. However, our experience tells us that things inevitably look bleakest before the tide turns”

“A third paradigm [in the financial press] is don’t try to hit home runs – you make the most money be hitting a lot of singles. I couldn’t disagree more. I believe you can make the most money hitting home runs. But, you also need a discipline to avoid striking out. That is my sell discipline. I try to cut my losses and let my winners run.”

“The current proliferation of electronic technologies computers, the Internet, cell phones, 24 hours news and instant analysis-tend to distract us from the essentially human nature of markets. Greed, hope, fear, and denial, herd behaviour, impulsiveness and impatience with process (‘Are we there yet?’) are still around, and if anything, more intensely so. Few people have absorbed the hard neuroscience research that reasons arrive afterwards. That given the choice between a simple, easy to understand, explanation that works and difficult one that doesn’t people tend to pick the latter. People would rather have any story about how a series of price changes happened than that there is no rational reason for it. Confusing hind-sight with foresight and complexity with insight are a few more ‘cognitive illusions’ of Behavioural Finance.”

History does not repeat itself: people just keep forgetting it: No matter how many stock market bubbles there have been, or will be, investors and their advisors always treat the current one as permanent, sometimes even calling it a “new era” In the meantime, others, myself included, have abandoned all hope of people permanently remembering the lessons of history.

Investment bubbles have always been a part of market history. For example, speculators in the Netherlands in the 17th century drove up the prices of tulip bulbs to absurd levels. The inevitable crash followed. Since then, from the Great Depression to the recent dot-com implosion, people can’t seem to steer clear from speculative manias. They make the same mistakes over and over again.

Further, “Investors” dislike losses so much that we will make irrational decision in vain attempts to avoid them. This helps explain, why some investors sell their winning stocks too early, but hold on to loser for too long, It is human nature to take the profit from a winner quickly on the assumption our win won’t last for long, and stick with a loser in the futile hope it will bounce back.

However, trend followers know if you don’t cut your losses will get larger. The more you struggle with your small loss, the larger it may become and the harder it may be to deal with if your decision-making is delayed. The problem we have with accepting a loss is that it forces us to admit we are wrong. We human beings just don’t naturally like to be wrong.

Any discussion of why investors are their own worst enemies, when it comes to being wrong, must start with sunk costs. A sunk cost is an investment of money and time that has already been incurred and that you can’t recoup. Thinking in terms of sunks lets you see loss for what it actually is – a loss. While we all know that sunk costs must not influence our present decision, we have a hard time forgetting the past. A person may buy more of a stock even though it is tanking simply because of the initial decision to buy it. The person can then say proudly, “I bought on a discount!” of course if the price of the stock never goes up again, as is often the case, this theory implodes.

Trend followers ignore sunk costs. If they buy and the market goes against them, they exit. “Take your small loss and go home” is their mantra. However, most of us are ambivalent when we have to deal with sunk costs. Although intellectually we know that there is nothing we can do about money already spent and we must move on, emotionally we dwell in the past.

According to any number of economic theories, conflicting feelings about money shouldn’t should exist. Human behavior should reflect a rational approach to money and not assign different values to the same products and the same values to different products. We are supposed to refuse to pay too much for a watch because of the social cache of a label. We are supposed to make intelligent objective choices that maximise our wealth and financial security.

But then what is the motivation behind the person who runs up credit card debt at 14 percent interest, but would never think of dipping into their savings account to pay off the debt? What is the explanation for people who spend time researching a new car or designer kitchen, but when it comes time to invest their retirement funds, refuse to learn or engage in any research?

Trend follower’s ability to delay gratification, stifle impulsiveness, and shake off the market’s inevitable setbacks and upsets, makes them successful traders

What feels good is often the wrong thing to do.

“One of the biggest mistakes most investors make is believing they’ve always got to be doing something…the trick in investing is not to lose money…the losses will kill you. They ruin your compounding rate; and compounding is the magic of investing.”

You can’t get rich overnight, but with compounding you at least have a chance. For example, if you manage to make 50 percent a year in your trading, you can compound and initial $20,000 account to over $616,000 in just seven years.

Buy-and-hold

After the stock market bubble burst in spring 2000, the concept of buy and hold as a trading strategy must have been shown as the failure it is once and for all. Yet, four years later, investors still buy and hold because they are unaware of the alternatives. Investors still obey mantras like: “Buy and hold for the long term.” “Stay the course.” “Buy the dips.” “Never surrender.” Buy-and-hold mantras are highly suspect because they never answer the basic question: Buy how much of what? Buy at what price? Hold for how long?

Consider the NASDAQ market crash of 1973-1974. The NASDAQ reached its high peak in December 1972. It then dropped by nearly 60 percent, hitting rock bottom on September 1974. We did not see the NASDAQ break permanently free of the ’73-’74 bear market until April 1980. Buy-and-hold did nothing for investors from December 1972 through March 1980. Investors would have made more money during this period in a 3 percent savings account. History repeated itself with the recent 77 percent drop in the NASDAQ from 2000-2002.

“The ‘buy and hold’ investor has been led to believe (perhaps by an industry with a powerful conflict of interest) that if he has tremendous patience and discipline and ‘stay with it’ he will make a good long term return. These investors fully expect that they will make back most, if not all, of recent losses soon enough. They believe that the best place for long-term capital is the stock market and that if they give it 5 of 10 or 20 years they will surely do very well. Such investors need to understand that they will surely do very well. Such investors may get no return at all and even lose money.

In the 80’s the Japanese were regarded as the smartest business men on the planet. Until trend reversed. In 1990 the Nikkei stood at 39,800, 20 years later it 10,000!

How can the trends (up and down) of Microsoft, Cisco, and Sun be ignored If you follow trends, you don’t need to know anything about tech companies to trade their trends. Your trading technique is designed to ride a trend, so neither company earnings nor value nor any other fundamental data is pertinent to your decision making. Furthermore, when Buffet says, “We want to buy stocks to hold forever,” what is he advising? Nothing is forever. Even high profile companies go bankrupt (Enron, WorldCom, Montgomery Ward, Wang, etc.). Assuming investors were able to accurately determine the value of a company for profit. Trading is not about buying into companies. Trading is about making money.

“If you had Enron in your portfolio and didn’t sell it at $90 or even at $10, don’t feel embarrassed. As Alfred Harrison, a money manager at Alliance Capital Management Holding LP, which owned a ton of Enron, put it, ‘On the surface it had always seemed to be a fairly good growth stock. We bought it all the way down.”

The longer a market declines, the more likely it is to continue declining. Falling markets must never be viewed as places to buy cheap.

If you work hard, save and adopt more realistic expectations, you can still retire rather than die in the harness. Earning maybe 9 percent on stocks isn’t as good as the 20 percent that you might have grown used to. But it’s not bad.”

But, saying 9 percent compounded is not bad compared to 20 percent compounded, ignores the pure math. Imaging the last 25 years and two investments of $1000 each. The first investment generated 9 percent for 25 years, and the second investment generated 20 percent for 25 years.

*$1000 compounded at 9% for 25 years = $8,600
*$1000 compounded at 20% for 25 years = $95,000

Here is the lunacy of buy and hold:

“Every major investor in the nation was heavily invested in WorldCom. They were one of the largest corporations in America.” – New York State Comptroller.

What was their plan? Their plan was the same as the state retirement plans of Michigan, Florida, and California that also lost in WorkdCom:

Michigan reported an unrealised loss of about $116 million on WorldCom.
Florida’s reported an unrealised loss of about $90 million on WorldCom.
The California Public Employees Retirement System. Ca1PERS, reported an unrealised loss of about $565 million on WorldCom.

Referring to $8.4 million in WorldCom stock now worth only about $492,000: “until you actually sell it, you haven’t lost it.”-Robert Leggett, Kentucky Retirement Systems.

The stock went to zero! The big companies don’t get it right.

In 2000, there were 28,000 recommendations by brokerage house analysts. At the start of October 2000…../99.1 percent of those recommendations on U.S. companies were either strong buy, buy, or hold. Just 0.9 percent of the time, analysts said sell. THE MARKET FELL OVER 50 AND TH NASDAQ EVEN MORE

The biggest cause of trouble in the world today is that the stupid people are so sure about things and the intelligent folks are so full of doubts.

However, it seems many ignore the data. Analysts go on TV, and viewers think to themselves, “She sounds bright; she works for JP Morgan of Morgan Stanley, and she’s using a lot of financial jargon that I don’t understand, so she must know something I don’t.” She doesn’t. The fact that so many analysts told you that you could buy so many stocks in the middle of the dot-com bubble – and were entirely wrong – must be permanent proof that analysts’ insight is not the answer. On top of that, the performance of most of Wall Street’s advice-givers is closely tied to current market movement anyway. What are you listening for?

“Merrill Lynch cordially invites you to an educational work shop Topic discussed:

Merrill Lynch Stock Market Forecast for 2002.
When will the recession end?
What do I do now?
What are the factors of a good stock market?
How did this bear market compare to others?”

If Merrill produced useless forecasts for the last five years, why would they assume anyone would believe their forecast in 2002? Merrill Lynch and other brokerages paid out a $1.4 billion dollar settlement. Why would you even want to trust them now?

Enron stock was rated as “Can’t Miss” until it became clear that the company was in desperate trouble, at which point analysts lowered the rating to “Sure Thing.” Only when Enron went completely under did a few bold analysts demote its stock to the lowest possible Wall Street analysts rating. “Hot Buy”

The key to long term success is not to be emotional, have a proven methodology that identifies trends at an early stage ,follows those trends, uses momentum to ensure you are in the best trends and protect against losses with stop loss exit strategy which identifies when the up trends have reversed.

Richmond Asset Management LTD has that methodology.