Trend-Following Balances Optimism and Pessimism

Absent a systematic and responsible plan, our emotions will run things. When shit hits the fan, we’ll be too scared to get in. When we hear some suited up analyst on television talking positively about the stock we own, we’ll be too hopeful to get out when the trend turns.

Systematic trend-following can help us avoid emotional biases that attend optimism and pessimism. An optimist may hold onto a losing position for too long, while a pessimist may exit a winning position too early or not get in at all. To succeed in this game, we have to stay alive and continuously take responsible risks.

Investors who have lived through a painful bear market tend to get gun-shy. They do all they can to avoid feeling the pain again. They say the markets are rigged and curse Wall Street as crooks. This isn’t going to help them win. They need to get back in the game, but in a responsible way. 

I learned a lot about the human condition during the Financial Crisis of 2008. When equity prices found their footing and began going up again during the middle of 2009, many people didn’t dare buy stocks again. The pain of the Crisis was too fresh and paralyzing.

“Buy stocks again!? We’re in the midst of a financial crisis. The market was making new lows just a few months ago!”

“I think the recent rally is overdone. We’re still in a bear market. I’m going to wait for a retracement then maybe I’ll get back in.”

The chart says it all. The blue circle indicates when the S&P 500 index made a new 52-week high. A sample size of one, sure, but this happens over and over again. How many people do you know that got back in in 2009? How many waited for years before doing so? Trend-Following takes action when it’s advantageous and responsible to do so.

Situations like this is where a system comes in handy. Even when emotions run high, you know what to do — either get back in, cut the loss or hold on. The rules run the ship, not your emotions. Feeling scared? Too bad. The trend is turning up again so we’re getting back in. The stock you hold is a really good company? Tough shit. The price is declining, so we’re getting out.

Rules. Rules. Rules. This is the way.