Commodity Trading Advisors (CTA) that utilize trend following through managed futures accounts have long known that there is no Holy Grail in investing.
When following trends, they know that anything can happen, so they have completely abandoned strategies involving fundamental analysis or buy-and-hold fallacies. Many successful trend followers and CTAs have developed trend following systems based on multiple time frames with the objective to harness the trend that herding generates in the market. In order to do that, their primary focus lies in managing risk so that the return would somehow take care of itself. Whenever they engage themselves in a trade, the potential loss is always known upfront.
In perhaps no other industry, subjective misjudgments become so blatantly obvious as in the trading business. Trend following tries to circumvent this. Behavioral finance has documented some of the investor biases explaining the rationale for trend following:
- Anchoring bias: Tendency to rely too heavily on one piece of information, specifically the recent price history to estimate “fair-value”.
- Bandwagon effect and feedback trading: Tendency for traders to act as a group and jump on the bandwagon of a rising price trend (herding).
- Confirmation bias: People tend to look for information supporting their beliefs and consider recent price moves to be representative of future prices. This leads investors to over-allocate funds to markets having already risen and under-allocate to fallen markets. This behavior favors trend continuation.
- Overreaction: Market participants overreact to new information, creating larger- than-warranted effects on market price and stronger trends.
The trend following industry prefers to analyze trends on a meta-level according to the Dow Theory: Higher highs and higher lows for an uptrend, or lower lows and lower highs for a downtrend.
Practitioners understand that the crowd is always collectively smarter and therefore do not bother to predict or outsmart the market with discretionary analytical methods. Instead, their goal is to participate in the crowd’s wisdom and follow the path as it is given to them without judgment.
Although you are spot on with those motivations don’t forget that often the best trends come from good old fashioned fundamentals as well. Most of us are making good money from the Euro downtrend, and look at the big inflation fueled trends of the 70s and early 80s. I’m not saying we have to anticipate or analyse them, but the best trends usually have a good underlying reason. I believe this is where trendfollowers generate much of their risk premium, taking the other side of the trade from commercials who are hedging lets say a substantial increase in the price of corn. Many of the cognitive biases of market participants also give us our profits from these factors, as most traders don’t want to take the ‘other side’ of the trade when Corn prices start rising and break out of an acknowledged range, appearing ‘too high’.