Connect through our academic library and discover a wide range of free-to-access academic and education resources.
Trend-following Education Resource Library
Discover a wide range of free-to-access academic and education resources that demonstrate the benefits of trend following.
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Risk management using trend-following
The first step in managing the risk of investing is to diversify i.e., spread investments across assets whose returns are not highly correlated). This implies holding a portfolio of different types of assets or assets of the same type with different exposures so that if one asset falls in value it does not mean that other assets will fall in value at the same time. However, even well-diversified portfolios holding hundreds of securities can suffer large drawdowns, or reductions in value, in a crisis (e.g., the 2008 Financial Crisis). For investors concerned about large losses, trend-following strategies have been shown, in the academic literature, to reduce the risk of large losses without significantly reducing long run returns.
Trend-following is generally the application of simple moving average rules. In simple terms, a moving average removes noise from the trend. These rules provide a signal that a market has turned down (or up) and therefore the investor should be selling (buying) the asset in that market. If an investor is selling the asset based on the trend following signal they should move into cash until the trend following signal indicates to repurchase the asset. Trend-following in many academic articles is also referred to as time series momentum.
M Faber ‘A quantitative approach to tactical asset allocation’
Journal of Wealth Management, Spring 2007 (updated 2014)
This was one of the first papers to demonstrate that applying a simple moving average strategy to each asset in an internationally diversified portfolio of assets, an investor is able to increase risk adjusted returns in a diversified portfolio. In addition, the investor would have also been able to avoid many of the protracted bear markets in various asset classes. Avoiding these massive losses would have resulted in equity-like returns with bond-like volatility and drawdown.
T J.Moskowitz, Y H Ooi,, L H Pedersen ‘Time series momentum’
Journal of Financial Economics (2012)
This article documents significant ‘‘time series momentum’’ in equity index, currency, commodity, and bond futures for each of the 58 assets they consider. It shows that a diversified portfolio of time series momentum strategies across all asset classes delivers substantial abnormal returns and performs best during extreme markets.
A Clare, J Seaton, P Smith, S Thomas ‘Breaking into the Black box: Trend following, stop losses and the frequency of trading - The case of the S&P500’
Journal of Asset Management (2012)
They find that over a historical period of 60 years, a range of fairly simple rules, including the popular 200-day moving average trend-following rule, dominate just passively holding an investment in the S&P index.
Wesley Gray, Alpha Architect ‘Avoiding the Big Drawdown with Trend-Following Investment Strategies’
Wesley Gray, PhD
Wes Gray at Alpha Architect is an advocate of trend following strategies and in this paper he presents a lot of evidence for different assets that using trend following as an investment strategy provides the possibility of lowering maximum drawdown risk, while also offering a chance to participate in a majority of the upside associated with a given asset class.
"We analyse the movement of stock market prices over differing time periods in order to decide if a market has rising momentum and should be bought or falling momentum and should be sold."
Prof Mike Buckle
Investment Manager
