What in the world is trend following?

Ever felt the sting of missing out on a soaring stock? Or clung to an “undervalued”, dropping investment hoping that it would magically rebound?

You’re not alone.

Let’s face it - Investing is difficult stuff.

Even the best fundamental analysts don’t get it right all the time. We have also seen how luck can play a significant role in investing, amplifying cognitive biases like the Dunning–Kruger effect.

The trend following concept, being mechanical by design, eliminates the need to predict future prices and operates based on pre-defined rules.

Here’s why this straightforward strategy might be the perfect fit for you.

Trends make money

Imagine a stock frozen in time. No movement, no profit potential. Essentially, all investing hinges on catching trends, up or down.

Value investors attempt to scoop up undervalued stocks. Their game? A future price surge. They use metrics such as price-to-book ratios to anticipate these reversals, essentially betting trends will shift in their favour eventually.

Even passive index fund investors rely on long-term upward market trends, holding onto the belief that assets would appreciate over time because of macroeconomic factors.

This begs the question: Why chase indirect metrics when you can focus directly on trends themselves?

Ditch the ego, follow the market

Trend following does not play the fortune-telling game.

Instead of trying to predict future prices, trend following requires surrendering your ego and following where the market leads. Nobody truly knows the future.

John Kenneth Galbraith aptly said, "There are two types of forecasters: those who don't know, and those who don't know they don't know." Trend following embodies this - identify established trends, then follow, not predict.

Ride the wave, maximize profits

Ever regretted passing on a stock you felt was “too expensive”?

Trend following does not care about price tags. It identifies trends, not valuations. As long as a trend is confirmed and entry rules are met, you're in the game. This reduces the chance of missing out on opportunities.

The beauty of trend following extends to maximizing profits. Sold a stock only to see it skyrocket? Trend following uses trailing stops to help you exit near the peak.

The idea: set a sell order below the current price, allowing for fluctuations. As the price climbs, the stop adjusts upwards, locking in profits while giving the price room to breathe. You can read more about trailing stops here.

Cut your losses and live to trade another day

Bought a "cheap" stock that just keeps dropping? The worst response? Holding on to those mounting losses.

Remember, what goes down, can go down even lower!

Trend following avoids this by always being prepared to be wrong.

Ego-free trend followers exit when the trend goes against them. They set stop-loss prices to automatically exit if the price reaches a certain point. This simple strategy safeguards capital and prevents emotional decisions.

Embrace the odds, play the numbers game

Trend following is not about guarantees. As a divergent strategy, not every trade will be a winner. But over time, winning trades with maximized profits will outweigh the losses kept in check by stop-losses. You can learn more about divergent strategies here.

The key to trend following is consistency. This method thrives on a diversified portfolio of assets. The more entries you make across different asset classes, industries and geographies, the higher odds of you capturing strong trends.

The takeaway

There are many ways to profit from the financial markets. There are few that adopt such a mechanical and rule-based approach as with trend following.

In essence, trend following boils down to one mantra: Cut your losers short and let your winners run.

Do this, and you’re one step closer to building a profitable and sustainable investment portfolio.

That’s it for today!

Got questions? Feel free to drop me a note. I respond to every email.

I’ll see you soon!