Trend Following is simply buying an asset when it is going up, *and,* you sell that asset when it is going down.

But…aren’t we supposed to buy assets when they’re going down, and sell assets when they’re going up?

Buy low, sell high…right?

From an intuitive perspective, trend-following makes no sense. We should buy things when they are down and sell them when they are going up!

But sometimes our intuitions can cause us to stray from the evidence. (spoiler alert: the evidence, historically, is that one wants to buy assets that are going up and sell assets that are going down).

Systems vs Intuitions

The key lies in whether you are doing things systematically or whether you are doing things based on your intuition. We humans are emotional. And it’s that emotional-ness combined with what we think we know where the issue lies.⁽¹⁾

A quick google search defined intuitions as, “a thing that one knows or considers likely from instinctive feeling rather than conscious reasoning.” Some investors have proven their intuition is great, with Warren Buffett being the most famous of them. But if you’re buying and selling based on your intuition, you’re making the assumption you are one of those gifted few that has an intuition that can outsmart the data.

Is that a good assumption?⁽²⁾

Probably not, and this is why we should follow systems that actually align with the historical data. In short, trend-following!

What types of assets can I trend follow?

Just about all asset classes can be trend followed. With most asset classes we studied throughout history if you trend followed that asset, you generally received similar returns to whatever that asset class already gave you, but cut your drawdowns significantly. *This is a key point to take away with trend following*. And this can then help us understand how it can be used in a portfolio.

Said another way, over long time periods (ten years or more) trend following is not something you should go into thinking it will give you higher returns than simply buying and holding an asset class, but it may help in reducing your worst drawdowns in that asset class.

Let’s take a look at four asset classes using our Alpha Architect trend following signals from January 1973 – September 2022: US Stocks, Real Estate (via REITS), Commodities (via a diversified basket of commodities), and 7-10 year treasury bonds.

For US stocks, bonds, and REITs you can see you got similar annual returns over that time period with your worst drawdowns being less if you trend followed. Commodities are interesting because you actually received better annual returns if you trend followed and received a lower worst drawdown if you trend followed. Is there something there? Maybe. But safe to have a more conservative expectation in the future and be happy if history repeats itself over the next 40 or so years.

How…do I use Trend Following?

For how to use it, let’s just reiterate some of the key points we already hit as that is our guide on how to use trend following.

1. Trend following may save your tail, but it doesn’t work perfectly all the time.
2. Trend following, when it works, seemingly gives you about the same overall returns, with a reduced drawdown over the long term.
3. Trend following an asset makes it perform differently than just buying and holding that asset.

Because of those statements above, trend following is probably best used as a part of your overall investment portfolio. We believe it’s an ideal addition to help diversify against your buy-and-hold assets with its potential to help on some drawdowns, the potential to provide similar returns, and its differentiated performance. That’s a generic answer, but personal finance is personal. If you’d like a more specific answer, reach out (or talk to your advisor!).