Why Does Trend Following Work

The March 2016 issue of the Journal of Financial Planning contains an interview with MIT Sloan School of Management Professor Andrew Lo, Ph.D. In the interview he explains the psychological reasons why the trading strategy of trend-following continues to work.  Here is an excerpt from that interview.

Trend following is certainly not new, it’s been around for decades now.  So you might ask, well, why does it persist?  If everybody wants to follow trends, then doesn’t that cause trends to disappear?  And the answer is no, it doesn’t, because there is something fundamental about how trends get created – it’s basically part of investor psychology.

Investors are not comfortable buying something unless they think they’re getting reasonable value.  And how they determine whether or not they’re getting reasonable value is partly from fundamental analysis, but part of it is also price momentum.  If they see a product going up in value, that actually makes it more attractive, not less, because they’re thinking about it as an investment, as opposed to a consumption good.

That’s a key difference between investments and other parts of economics.  Think about the price of gasoline.  If gasoline goes up by $3 a gallon, you’re probably going to drive around a lot less.  You’re probably going to buy smaller cars and stay away from SUV’s, and vice versa if the price of gasoline goes down.  But gasoline is not an investment good; it’s a commodity that you consume.  If you think about an investment, the more an investment goes up, the more you think it’s got prospects of going up even farther.  A classic example is modern art.  You can buy a painting for $100, but if I tell you that this painting actually sells for $10,000, but it was $5,000 last year, that will make you want it even more.

So that’s an example of why trend following works – it works because people actually respond to trends and continue to buy as prices are going up.  It doesn’t work forever, and trends certainly break and reverse, so it’s not a fool-proof strategy, but it’s something that is persistent and part of human psychology, and, therefore, trend-following strategies are going to benefit from that over time and be able to earn a reasonable expected return for investors given the level of risk that’s involved.

The fact that human nature is at the root of trend-following’s continued success gives the investor an advantage.  Strategies that fight human nature are pushing against an invisible friction.  Like the Atkins diet that calls for avoidance of sugar.  Going against human nature won’t work long-term.   To increase your odds of success, you or your money manager should use a strategy that has human nature working for it.

 

To read more about investing strategies, try my blog post titled “What Investment Strategy are You Using Now?”

 

Why Does Trend Following Work