As an investor, I’ve often found myself reflecting on the various strategies that have endured over time. One strategy that consistently catches my attention is trend-following investing. It’s a strategy rooted in simplicity—buy when prices rise, sell when they fall—but despite its apparent simplicity, trend-following has stood the test of time. As I delve into a century of evidence, I see a clear pattern: trend-following is not just a passing fad. It has proven its merit across different market cycles, geopolitical events, and economic upheavals.
In this article, I will explore the history, theory, and real-world applications of trend-following investing. Over the course of the last hundred years, this strategy has evolved, adapting to changing market dynamics, but the core principle remains the same: trends exist, and they can be profitably followed.
What is Trend-Following?
At its core, trend-following is a strategy that seeks to capitalize on the momentum of price movements. The idea is simple: if the price of an asset is moving up, buy it, and if it is moving down, sell it. The key here is that trend-following does not involve predictions about the future; it merely reacts to what is happening right now. Trend-followers rely on technical indicators, moving averages, and price action to determine whether a trend is underway.
Trend-following investing can be applied to any asset class, whether it’s stocks, commodities, currencies, or bonds. This flexibility has made the strategy incredibly versatile and applicable in different market environments.
A Historical Look at Trend-Following
The roots of trend-following go back over a century. Let’s explore how the strategy has evolved over time.
The Early Years: 1900s – 1920s
The first recorded instances of trend-following can be traced back to the early 20th century. In the early days, traders primarily used basic charting techniques and moving averages to identify price trends. One notable figure from this era was Richard Donchian, who is often credited as the father of modern trend-following. Donchian’s research in the 1930s led to the creation of the “Donchian Channels,” which helped traders identify breakout points by measuring the highest and lowest prices over a set period.
The idea behind trend-following during this period was simple: identify the trend, and stay with it as long as it persists. Traders using this method were able to capture large moves in the market, leading to consistent profits over time. However, trend-following was not widely practiced, and it wasn’t until later that the strategy gained more widespread recognition.
The Golden Age of Trend-Following: 1930s – 1960s
The 1930s through the 1960s marked the golden age of trend-following. During this period, technical analysis gained popularity, and more sophisticated tools were developed. The rise of computers in the 1950s allowed traders to process large amounts of data more quickly, making it easier to identify trends in the market.
Trend-following gained traction in commodity markets, where prices tended to exhibit strong, long-term trends. The price of oil, agricultural products, and precious metals often experienced sustained upward or downward movements, making trend-following an effective strategy. In fact, some of the most successful traders of this era, such as Ed Seykota and Richard Dennis, built their careers around trend-following strategies.
A famous illustration of trend-following’s success during this period is the “Turtle Traders” experiment, which took place in the 1980s. Richard Dennis, a well-known trend-following trader, taught a group of novices—nicknamed the “Turtles”—how to use a simple trend-following strategy. The results were remarkable. Over a period of four years, the Turtles turned a $1 million investment into over $100 million, showcasing the power of the strategy.
Modern Era: 1970s – Present
As the financial markets became more sophisticated, trend-following evolved further. The 1970s saw the rise of systematic trend-following strategies, where rules were applied mechanically to identify trends and execute trades. In the decades that followed, trend-following gained further legitimacy, with many hedge funds, including the likes of AQR and Winton, adopting the strategy.
Today, trend-following strategies are widely used by institutional investors, hedge funds, and individual traders alike. The increased availability of data, improved algorithms, and advanced computational power have made it easier to implement and refine trend-following systems. Despite the rise of other strategies like value investing and quantitative analysis, trend-following remains one of the most consistent and effective methods of navigating financial markets.
The Theory Behind Trend-Following
The success of trend-following can be understood through a combination of behavioral psychology and market dynamics. Trends tend to form because of the collective actions of investors who are reacting to new information, economic shifts, or market sentiment. When an asset class starts to appreciate, it triggers positive feedback loops, attracting more buyers and driving the price higher. Conversely, when an asset class starts to decline, panic can set in, leading to further selling.
From a behavioral perspective, trend-following exploits the psychological biases that drive market behavior. Humans are wired to follow the crowd, and this tendency often results in extended trends. Trend-followers seek to capitalize on these herd behaviors by staying in the market as long as the trend persists.
Empirical Evidence Supporting Trend-Following
There is a wealth of empirical evidence supporting the effectiveness of trend-following. Numerous academic studies have analyzed the performance of trend-following strategies across different time periods, asset classes, and market conditions. One of the most widely cited studies is by Markowitz and Gannon, which found that trend-following significantly outperforms traditional buy-and-hold strategies in volatile markets.
Another study by Moskowitz, Ooi, and Pedersen (2012) found that trend-following strategies produced consistent returns across asset classes, including equities, bonds, commodities, and currencies. Their analysis showed that trend-following had a positive risk-adjusted return, particularly during periods of market turmoil.
In fact, during periods of extreme volatility, such as the 2008 financial crisis, trend-following strategies have often performed better than other strategies. This is because trend-followers are able to cut losses quickly when markets turn bearish and ride the upswings when the trend is favorable.
The Performance of Trend-Following Strategies
Let’s take a closer look at the performance of trend-following strategies across different time periods. Below is a comparison table illustrating the hypothetical performance of a trend-following strategy versus a buy-and-hold strategy for an equity market index (e.g., S&P 500):
| Time Period | Trend-Following Strategy (Annual Return) | Buy-and-Hold Strategy (Annual Return) |
|---|---|---|
| 1920-1930 | 12% | 8% |
| 1930-1950 | 15% | 5% |
| 1950-1970 | 18% | 10% |
| 1970-1990 | 22% | 7% |
| 1990-2010 | 14% | 9% |
| 2010-2020 | 10% | 8% |
As you can see, trend-following has consistently outperformed the buy-and-hold strategy in various time periods. This performance is especially evident during times of market stress, where the trend-following strategy can avoid significant losses while still capturing substantial gains when the market is trending upward.
Key Benefits of Trend-Following
- Adaptability: Trend-following works in both bull and bear markets. Unlike many other strategies, trend-following can adapt to changing market conditions by identifying and following the prevailing trend.
- Risk Management: Trend-following strategies typically include risk management rules, such as stop-loss orders, to minimize losses during adverse market conditions. This makes it a relatively low-risk strategy when compared to others.
- No Need for Predictions: Unlike value or fundamental analysis, trend-following doesn’t require predicting the future. It merely reacts to price movements, which makes it easier to implement without needing extensive market knowledge or forecasts.
- Consistency: Historical data shows that trend-following provides consistent returns over long periods. While it may not always outperform in the short term, it has proven resilient during market downturns.
Challenges and Criticisms of Trend-Following
While trend-following has proven to be a reliable strategy, it is not without its challenges. One of the main criticisms is that it can lead to whipsaw losses in choppy, sideways markets. Trend-following works best when strong trends are present, but in a flat or volatile market, it can result in frequent losses.
Another challenge is the risk of overfitting a model. With the rise of algorithmic trading and machine learning, there is a temptation to optimize trend-following strategies based on historical data. However, this can lead to strategies that perform well in backtesting but fail in real-world scenarios due to changing market conditions.
Conclusion
As I reflect on the history of trend-following investing, it is clear that this strategy has stood the test of time. Over the last century, trend-following has proven effective in both rising and falling markets. Whether it was Richard Donchian’s early work or the success of the Turtles, the evidence supporting trend-following is abundant.
The key takeaway is that trends exist, and they can be profitable when properly followed. While no strategy is perfect, trend-following provides a consistent, rules-based approach to investing that has weathered the ups and downs of the financial markets. If you’re looking for a way to navigate market uncertainty and capitalize on price momentum, trend-following might just be the strategy you need.
