Reading Article
Trend Following – Profits from Sticking with a Trend
Riding trends leads to large profits because markets are prone to excessive behavior.
For example, most people realized the price of the NASDAQ had reached extreme levels back in the late 1990’s.
Yet, as you can see in the first chart below, even during the early months of 2000, the index continued to trend upwards.
Expert stock valuers were telling investors to sell the NASDAQ in late 1998 and 1999 because the fundamentals could not support the high levels the market was reaching.
Let’s imagine – at the beginning of 1999 – that you decided to ignore the dire predictions and get a piece of the NASDAQ action. You were cautious though.
You decided to wait for a confirmed uptrend to start. The second chart below shows that you got one.
Let’s say you bought at close of business on June 16 1999. The NASDAQ closed on that date at 2,517. Your strategy was to hold until the uptrend broke.
This happened around 11 October 2000.
Let’s say you sold at close of market on that day, when the market was worth 3,168.
Some strategies could have caused you to sell earlier than this for a greater profit. In this case, however, we will assume you acted on the indications provided by simple trendlines.
The result would have been that in a period of 16 months you would have made an annualized gain of around 20 percent. Not spectacular, but very good.
Price Chart for the NASDAQ 1999 and 2000
Price Chart for the NASDAQ 1999 and 2000 With Trendline
Compare this with a buy and hold strategy, starting on the same date. Instead of selling when the trend broke, you continued to hold until July 7 2006, when the NASDAQ closed at 2,130. You sold on this day because you were fed up of the underperformance of your investment. You have suffered a loss of 15 percent after 7 years. Although this is dreadful, it is still better than the performance of some buy and hold investors who bought near the peak of the market.
We have cited the NASDAQ’s behavior as an example of stock market prices rising unrealistically high. Individual stocks behave every bit as irrationally as the NASDAQ did. Waves of market optimism carry prices higher than fundamentals should allow them to go. Prudent traders stick with these high-flying stocks, however, until the trend is over. This is how they maximize their profits.
Waves of market sentiment can also carry a stock’s price lower than its underlying financials should allow it to go – if the sentiment is negative. Even though a stock might appear undervalued, prudent investors wait for the downtrend to end before buying into the stock. There is no point “catching a falling knife” – you’ll just get cut. Wait until the knife hits the floor and the downtrend is over before investing in a stock.
Summary
Successful investors have a selling strategy that allows limitless gains and prevents unlimited losses. Successful investors execute their strategy ruthlessly.