The Body
In this segment of Rules-Based Money Management, we shall delve into the working mode of trend following, a fundamental investing strategy. Despite being dismissed by some as overly simple, trend following has proved itself an effective method of money management for many investors due to its quantitative nature and reduction in decision-making bias. This article will explain how trend following works, what makes it effective, and how to put it to good use in rules-based money management.
First and foremost, let’s understand what trend following truly signifies in the investment world. This strategy assumes that the financial markets will move within a certain trend, either upwards or downwards. Investors using this approach aim to seize profitable opportunities by identifying these trends, buying assets when they see upward trends, and selling assets when they see downward trends. Essentially, the crux of trend following lies in riding an invested asset’s momentum until it shows signs of reversal.
Next, let’s understand why trend following assumes significantly high importance in rules-based money management. A major strength of trend following is its characteristic of being systematic and data-oriented, eliminating emotional influences on investing decisions. By using past market data and established indicators to determine the presence, direction, and strength of a trend, trend followers take objectivity and consistency to a new height. Moreover, trend following includes a predefined exit point, minimizing losses when the trend changes. This makes it an inherently risk-managed strategy.
How does one identify a trend? It might sound complicated, but several technical indicators can help us. Moving averages, relative strength index (RSI), and the average directional index (ADX) are a few tools that most trend followers use. Moving averages, including the simple moving average (SMA) and the exponential moving average (EMA), provide a smoothed line of an asset’s price data over a specified period, helping to identify persistent price directions. The RSI, on the other hand, measures current price strength relative to previous prices, indicating an overbought or oversold state of an asset. The ADX quantifies a trend’s strength, providing insights into a trend’s robustness.
Once the trend is identified, the next step is to decide when to enter or exit trade. A trend follower will often enter a long position when an upward trend has been established and confirmed by these technical indicators. Conversely, a trend follower will exit their position or enter a short position when a downward trend is evident. Having a predetermined set of rules for entry and exit can enhance the effectiveness of this strategy.
Lastly, it’s crucial to note that trend following doesn’t aim to predict market moves or win every trade. Instead, it relies on the principle that trends tend to persist for a while, and capturing these trends can lead to profitable trades that offset the losses from losing trades.
In conclusion, while trend following might seem elementary and modest on the surface, when equipped with the right set of rules, tools, and patience, it has proven to be a robust strategy. When implemented as part of a systematic, rules-based money investment strategy, trend following can provide consistent returns over time and aid in efficient risk management. Like any investment strategy, trend following isn’t foolproof and requires continuous learning and fine-tuning. However, its core principle of maintaining objectivity and consistency aligns well with the overarching philosophy of rules-based money management.
