Trend Following on Stocks: Maximizing Returns and Managing Risk

Trend following is a popular investment strategy that has traditionally been applied to futures markets. However, research shows that trend following can also be highly effective when applied to individual stocks. In this article, we'll explore the concept of trend following on stocks, its benefits, and how it compares to other investment approaches.

What is Trend Following on Stocks?

Trend following on stocks is a systematic investment strategy that aims to capture large price movements in individual equities. The basic premise is simple:

• Buy stocks that are making new all-time highs (in an uptrend)
• Sell stocks when they fall below a certain threshold (exit the downtrend)

While this may seem counterintuitive to many investors who prefer to "buy low and sell high," trend following capitalizes on the tendency of winning stocks to continue winning and losing stocks to continue losing.

Key Benefits of Trend Following on Stocks

Applying trend following principles to individual stocks offers several advantages:

1. Capturing Big Winners

One of the most powerful aspects of trend following on stocks is its ability to ride big winners for extended periods. Research shows that a small percentage of stocks are responsible for the majority of market gains over time. By systematically identifying and holding onto these top performers, trend following strategies can generate outsized returns.

As Cole Wilcox of Longboard Asset Management notes:

"In the paper, we over that 60,000 back test to the 50s, only 7% of the trades were responsible for 100% of the strategies total gains. And that 7% is going to be positions that you held on to a very, very long time that were kind of like the super trends that did very well."

2. Limiting Losses

While capturing big winners is crucial, equally important is the ability to limit losses on losing positions. Trend following accomplishes this through systematic exit rules, typically based on a trailing stop loss. This prevents small losses from turning into large, portfolio-damaging losses.

3. Emotional Discipline

By following a rules-based system, trend following removes much of the emotional decision-making that often leads to poor investment outcomes. There's no agonizing over whether to sell a losing position or take profits on a winner - the system dictates the appropriate action.

4. Tax Efficiency

Trend following on stocks can be more tax-efficient than many other active strategies. As Wilcox explains:

"It does have a vastly superior tax efficiency to it because you tend to be harvesting losses every year and then you're deferring gains on the long-term winner type stuff and then when you end up do have those realized gains, you have this whole bucket of other losses that you've been accumulating over time that you can offset it against."

How Trend Following on Stocks Differs from Traditional Trend Following

While the core principles are similar, applying trend following to individual stocks differs from traditional futures-based trend following in several key ways:

1. Asset Class Characteristics

Stocks have unique characteristics compared to futures contracts:

• They can theoretically rise indefinitely (unlike futures which have defined price ranges)
• They pay dividends, which can be reinvested
• They're tied to underlying businesses that can grow and compound value over time

2. Universe of Opportunities

The stock market offers a much larger universe of potential trades compared to futures markets. This increased opportunity set allows for greater diversification and the potential to capture more trends.

3. Correlation and Crisis Performance

Traditional trend following strategies often shine during market crises, as they can go short stock indices and long safe-haven assets like bonds. Stock-only trend following may not offer the same degree of crisis alpha, but it can still provide meaningful downside protection through its ability to move to cash.

Implementing Trend Following on Stocks

For investors interested in implementing a trend following approach to stocks, there are several considerations:

1. Define Clear Rules

Successful trend following requires clearly defined rules for entries, exits, and position sizing. These rules should be based on robust research and backtesting.

2. Maintain Discipline

The biggest challenge for many investors is sticking to the system, especially during periods of underperformance. It's crucial to maintain discipline and trust the process.

3. Manage Risk

Proper risk management is essential. This includes using appropriate position sizing, diversifying across many positions, and having clear exit criteria for all trades.

4. Consider Professional Management

For many investors, implementing a trend following strategy on their own can be challenging. Investing in a professionally managed fund that follows this approach may be a more practical solution.

The Role of Trend Following on Stocks in a Portfolio

Trend following on stocks can play a valuable role in a diversified investment portfolio. Some key considerations:

1. Return Enhancement

By systematically capturing big winners and limiting losses, trend following on stocks has the potential to enhance overall portfolio returns.

2. Risk Management

The ability to move to cash during prolonged downtrends can help manage overall portfolio risk and reduce drawdowns.

3. Diversification

Trend following strategies often have low correlation to traditional buy-and-hold equity strategies, providing valuable diversification benefits.

4. Behavioral Benefits

Having a portion of the portfolio allocated to a rules-based strategy can help investors stay the course during market turbulence.

Challenges and Considerations

While trend following on stocks offers many potential benefits, it's important to be aware of some challenges:

1. Whipsaws

Trend following strategies can suffer from whipsaws - getting stopped out of a position only to see it reverse and continue in the original direction.

2. Underperformance in Certain Markets

Trend following may underperform in choppy, range-bound markets where clear trends fail to develop.

3. Psychological Challenges

Despite being rules-based, trend following can still be psychologically challenging. The strategy often has a low win rate (many small losses offset by fewer big wins), which can be difficult for some investors to tolerate.

4. Implementation Costs

Depending on the specific approach, trend following on stocks may involve higher turnover and associated trading costs compared to buy-and-hold strategies.

Conclusion

Trend following on stocks represents a powerful approach to equity investing that combines the potential for capturing outsized gains with robust risk management. By systematically identifying and riding strong trends while cutting losses short, this strategy offers a compelling alternative to traditional buy-and-hold investing.

While not without its challenges, trend following on stocks has demonstrated its effectiveness over long periods and across various market environments. For investors seeking to enhance returns, manage risk, and diversify their portfolios, trend following on stocks is certainly worthy of consideration.

As with any investment strategy, it's crucial to thoroughly understand the approach, its strengths and limitations, and how it fits within your overall financial plan. Whether implemented through a professionally managed fund or as part of a personal investment strategy, trend following on stocks offers a unique and potentially valuable tool for navigating the complex world of equity investing.

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