Market trends are the most powerful drivers of long-term investment performance

In my April report I suggested that effective trend following required discipline and a good deal of patience. In this report we discuss the strategy’s proper objective, which leads compellingly to the conclusion articulated in this article’s title.

We are after outsized, long-term windfalls

Many individual traders obsess over short term gains or even day trading. The appeal of day trading is that it offers a degree of entertainment like playing in a casino. Unfortunately, the results of short-term trading tend to be similar to casino gambling for most traders.

By contrast, trend following is about positioning your investments for large-scale price events. For perspective, here are a few examples of these large-scale price events or trends:

This is only a small sample: in reality trends happen all the time in just about every market. Because these events may take months or years to unfold, trend following requires patience and does not entail frequent short-term trading.

In fact, most investors intuitively understand the best way to profit from their investments is through great trends, not frequent short-term betting. Accordingly, many of them hope to discover the new Apple, Microsoft or Amazon – a life changing investment that could appreciate multiple times over the years.

In real-estate also, profiting from investments usually entails owning a property for years as its value appreciates long-term. Even markets for such unusual items as New York taxi medallions clearly manifest trends:

With this broader perspective, we can appreciate that the greatest driver of investment gains are the large-scale trends that unfold over sustained time periods.

Momentum investing

The role of price trends in driving investment returns also explains the remarkable performance of momentum investing – buying stocks that have appreciated the most. The chart below shows the performance of stock portfolios consisting of best performing 20% of stocks, compared to the worst performing 20% and the middle 60%:

One British pound invested in 1900 in the top 20% of stocks grew to 2,300,000 at the end of 2009. By contrast, investing in the bottom 20% of stocks turned 1 GBP into 49 GBP (for more details on this study please click on this link). The implications of this study could not be clearer: investing in best-performing stocks generated best investment returns. Investing in laggards generated poor results.

But what of value investing?

Momentum investing contradicts value investing and the stellar performance of such legendary value investors like Benjamin Graham and Warren Buffett. But closer scrutiny of Graham’s and Buffett’s investments and their writing reveals that their outperformance had been driven entirely by trends and momentum investments. This may sound sacrilegious but you’ll find my analysis difficult to refute (please follow this link).

Why use systematic trend-following?

Even those investors who do recognize promising new investments like Amazon, Google or Apple seldom manage to take full advantage of such investments. The reality is that most of us cash out far too quickly.

Consider the story of Leo Melamed’s mythical 1978 Silver trade. Melamed was the chairman emeritus and senior policy advisor to the Chicago Mercantile Exchange and one of the most eminent commodities traders in his time. In June of 1978, he bought Silver futures at about $5 an ounce. By October 1979, silver had rallied to $15 an ounce. Mr. Melamed made a small fortune on that trade and decided to cash out – only to see Silver more than triple to $50 an ounce over the following three months.

In his book, “Escape to the Futures” he wrote: “why was this my worst trade when in fact it was the biggest profit I had ever made up to that time?” It was for the same reason why I sold out of my 1998 investment into Amazon.com stock shares after they had appreciated about 15-fold. I was very happy with my gains, except that Amazon.com appreciated another 24-fold after I had sold my shares.

It’s about our own psychology

Benjamin Graham famously wrote that, “investor’s chief problem – and even his greatest enemy – is likely to be himself.”

Part of that problem is our hardwired tendency to be strongly risk-averse with respect to profits and risk-seeking when we face losses: we tend to exit profitable trades too early (in order to preserve a favourable outcome) but we ‘work’ the losing trades for too long (to try and reverse the losses).

This tendency was described by psychologists Daniel Kahneman and Amos Tversky who named it failure of invariance. Failure of invariance is among the key reasons why most traders lose money and most professional managers underperform their benchmarks.

Systematic trend following helps us avoid some of the pitfalls of our psychology and take full(er) advantage of trends, even if they advance to levels that may seem unthinkable in the present moment.

Profiting from the unthinkable

In 1971 the price of Gold had been fixed at $35/ounce for more than 30 years. Mounting economic imbalances prompted the US Treasury to devalue the USD to $38/ounce in 1971 and again to $42 in 1973. It was hoped that these devaluations would be sufficient to redress the imbalances. However, within 1973 the price of Gold reached $90 and in 1974 it rose to “unthinkable” three digit $105/ounce.

Tripling of the gold price in just over two years’ time was a shock, but these were only the beginnings of the trend that would last through January 1980 and reach $850/ounce. This was the same market environment in which Leo Melamed made his best worst trade. It was also the environment that saw systematic trend following gain recognition as a legitimate investment strategy.

By using systematic trend following investors can overcome three important problems:

1. Uncertainty (the inability to know the future)
2. Psychology (emotions, distraction and other psychological pitfalls that have detrimental impact on our trading performance)
3. Knowledge limitations (supplanting market-centric or industry-centric skills with trend following skills that can be applied in many different markets, allowing investors to expand their investment horizons and trade in a broad range of un-correlated markets)

These are the benefits we sought to gain and successfully gained by developing the I-System.

Why I believe I-System is (probably) the best trend following model ever built

This is an audacious claim but in this article I tried to explain why one unique feature of the I -System makes the claim very probably true.

In the mean time you can test I-System decision support by subscribing to our TrendCompass reports. First month is free!

Alex Krainer, 08 Jun 2020.