In my last article, I introduced the investment strategy of trend following – and my reluctance to believe in it. In the end, the evidence was too overwhelming for me to ignore. A trend following screen on stocks did appear to reduce an investor’s risk (especially of big market drops) while achieving similar returns as a buy-and-hold strategy.
But I couldn’t shake my suspicion that something wasn’t quite right. One of my core beliefs (perhaps “the” core belief) is that investing strategies that enhance your returns (or give you equal returns at lower risk) over simply owning an index fund should cause pain. If they don’t cause investors pain and investment advisors to get fired, everyone would use them, and they would disappear.
Where was the pain in trend following? How could following this strategy get me fired?
Then it hit me. I was looking at the numbers of using trend following, but I wasn’t looking at the human experience for investors over the long run. From that angle, I realized that trend following is a pain train; it’s almost designed to get me fired. (I was beginning to warm up to trend following.)
First, a trend screen on stocks doesn’t work most of the time. (Hmm, maybe you can’t time the market.) Yeah, getting out of stocks when they started to trend down was great in 2008 and 2009, but what about in 2011 when the S&P 500 fell 16% over several months – triggering our trend screen and moving the portfolio to cash – only to shoot right back up to new highs while we sat in cash waiting for the trend screen to signal the “all clear” to move back into stocks.
You can see in the chart below how the trend screen would have caused us to sell just as the market bottomed out and to buy back into the market after missing a large run up in price. We ate all of the downturn but missed a good part of the rebound.
For Illustration Purposes Only
Similar market moves – known as “whipsaws” – happened again in 2010 and 2016.
By its nature, trend following is a defensive strategy. As soon as trouble starts to appear, it moves you to cash and waits until the coast is clear before going back in. It’s geared to avoid the big crash. But that protection comes at a price: You will miss out on gains during bull markets when stock downturns are temporary hiccups on the way to new highs.
In essence, a trend screen is like an insurance policy: It pays off big during a disaster, but during good times, you’re out the cost of the premiums. Over time, they even out.
We can see this by breaking down the annualized returns of two portfolios over the last decade. The first portfolio used a 10-month moving average trend screen to decide when to be in the S&P 500 index and when to be in cash. The second portfolio simply bought and held the S&P 500 index.
The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index.
The returns are exactly what you’d expect to see. The trend following portfolio did a great job during the bear market of 2008 to 2009 but has solidly trailed a buy-and-hold strategy during the bull market. Taken together, the overall annualized returns were fairly similar.
While I’m sure that investors would have been glad to have the trend following portfolio during the dark days of the Great Recession, I’m not sure how many investors would be willing to put up with the subsequent eight years of underperformance.
Trend following seems to have the same downside as other factor premiums (small, value and momentum): Long periods of underperformance that the vast majority of investors are not willing to accept.
It also has an added psychological hurdle: It looks like market timing. And perhaps it is, though it’s a strange type of market timing in the sense that it openly acknowledges that it doesn’t work most of the time.
Those caveats aside, trend following has a number of inviting attributes. First, it does seem to generate similar long-term returns as buy-and-hold but at less risk. Second, it complements buy-and-hold extremely well. Just as stocks and bonds pair nicely because they often do well when the other is doing poorly, trend following typically does well right at the time that buy-and-old is doing poorly (bear markets) while buy-and-hold portfolios typically do well when trend following portfolios struggle (bull markets).
Despite my early hesitations, I’ve come to believe that allocating a portion of an investor’s portfolio to a trend following strategy can be a useful addition.
However, I also believe that this strategy is not for many (maybe even most) people. For some (and do I understand this group), the feeling that they’re timing the market will never let them feel comfortable with trend following. For others, the fact that it doesn’t work most of the time will frustrate them into quitting the strategy. And, of course, for many investors, the long periods of underperformance relative to a benchmark will cause them to abandon the strategy before it can work.
As always, the best investment plan isn’t the plan that earns you the highest rate of return; it’s the investment plan that lets you sleep at night and that you can stick with during the inevitable periods of poor performance.