This is a Trend Following Guest Post by Michael Melissinosn his Blog

We can approach the markets many different ways. In this article, I’d like to illuminate the trouble with holding onto our investments too tight — that is, not giving them the necessary rope to fluctuate and evolve into a big trend.

With a tight grip (a short-term view), we get in and out more frequently — reacting to every little wiggle. The allure: that we can earn profits on most of our trades; buy in closer to bottoms and sell out closer to tops; also, we feel more productive and do not have to feel boredom.

With a loose grip (a long-term view), we try to ride the large trends that persist over months and years. We do not get greedy trying to pick bottoms or tops, but instead focus on capturing the meat of the move. We give the market room to oscillate up and down as long as it trends in a general direction. We’re OK with doing nothing, going long periods of time without making any trades and enjoy waiting for opportunity.

In this post, we use a counter-intuitive approach to investing — buying high and selling low. Most of you are likely familiar with the classic “buy low, sell hi” methodology. There are many problems with this approach, but we’ll save that for another post.

Buying highs and selling lows accomplishes two things: 1) we do not miss out on big trends; and 2) we protect capital by cutting our losses during bear markets (downtrends).

Short-Term Investing

Short-term investors want to ride lots of small moves. They play the back and forth game of the markets in the attempt to make quick profits and sell out.

In this first example, we use a simple indicator to buy and sell — the 3-month price channel. It calculates the highest high and lowest low for the past three months. We buy when the price breaks above the 3-month high and sell when the price breaks below the 3-month low. For simplicity’s sake, we only take long positions.

In the chart below, notice how tight the green (buy) and red (sell) bands are and how often this system makes trades (21 buy signals in 18 years). One of the risks of having a short-term view (a tight grip) is that you can get whipsawed during persistent up and downtrends.

Executing a short-term system in real time can get frustrating and wear on your ability to follow it, especially during choppy trend periods; also, and this goes for any strategy, when your feelings about the markets conflict with the system’s signals.

In and out. In and out. In and out. The perfect system for those who cannot sit still.

Long-Term Investing

Long-term investors want to ride major trends without getting knocked out of their position by insignificant market noise. In order to accomplish this, we de-sensitize our indicator by expanding it to a 12-month channel.

We buy when the price breaks above the 12-month high (blue box); sell out when the price breaks below the 12-month low. Same deal as before — we only take long positions; no shorts.

This approach trades much less frequently and typically only changes its stance after a significant change in trend. For example, in the 2001–2002 bear market, you would’ve to waited until the market rallied ~35% off the lows before buying in; in 2009, you would’ve watched a 60% rally off March lows before finally buying in.

It can go years without making a trade. Like the short term system, this one can also be difficult to execute — especially during violent changes in trend near tops and bottoms.

Get in the big uptrends. Stay out of the big downtrends.

The Results — Patience and Boredom Pay Of

The system that maintains a long-term view (loose grip), adapts to trends and cuts losses during downtrends makes the most money.

Buy and Hold comes in second place.

Short-term (tight grip) trend-following investing comes in third. It makes money, sure, but it severely underperforms. These results illuminate the problems that come with trying to ride short-term trends.

Can you imagine the results if we scaled down the short-term indicator to 3-weeks or 3-days from 3-months? The market would eat those strategies alive.

Results depend on how often you change your mind.

Bang For Your Buck

Both trend following systems beat the Buy-and-Hold strategy on a risk-adjusted performance basis (as measured by the MAR and Sharpe ratios).

The short-term system suffers almost half the loss Buy-and-Hold does. This is a good thing. But it underperforms on an absolute return basis (CAGR) — which is due to getting whipsawed in choppy trend environments.

The long-term system crushes everyone. Absolute returns vs the others? Crush. Risk-adjusted returns? Crush.

Having a long-term view, adding a simple layer of sophistication (getting out when the trend turns down) makes all the difference. It allows to capture upside while reducing downside risk; protecting your capital at all times and allowing you to buy back in later with a lot of dry powder.

You have to be honest with yourself and understand that while short-term thinking may feel good, it doesn’t always produce the best results — especially over the long run. When you do the work, like we’ve done in this post, you cut through the BS that is sold across Wall Street and you save yourself a lot of time, stress and money in the process.

Seems like a no brainer to me.

MAR = CAGR / Max Loss; Sharpe = CAGR / Standard Deviation

Michael Melissinoscan be found on twitter @mmelissinos  or his website at www.michaelmelissinos.com

Disclaimer

HYPOTHETICAL PERFORMANCE RESULTS HAVE MANY INHERENT LIMITATIONS, SOME OF WHICH ARE DESCRIBED BELOW. NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFITS OR LOSSES SIMILAR TO THOSE SHOWN. IN FACT, THERE ARE FREQUENTLY SHARP DIFFERENCES BETWEEN HYPOTHETICAL PERFORMANCE RESULTS AND THE ACTUAL RESULTS SUBSEQUENTLY ACHIEVED BY ANY PARTICULAR TRADING PROGRAM.

ONE OF THE LIMITATIONS OF HYPOTHETICAL PERFORMANCE RESULTS IS THAT THEY ARE GENERALLY PREPARED WITH THE BENEFIT OF HINDSIGHT. IN ADDITION, HYPOTHETICAL TRADING DOES NOT INVOLVE FINANCIAL RISK, AND NO HYPOTHETICAL TRADING RECORD CAN COMPLETELY ACCOUNT FOR THE IMPACT OF FINANCIAL RISK IN ACTUAL TRADING. FOR EXAMPLE, THE ABILITY TO WITHSTAND LOSSES OR TO ADHERE TO A PARTICULAR TRADING PROGRAM IN SPITE OF TRADING LOSSES ARE MATERIAL POINTS WHICH CAN ALSO ADVERSELY AFFECT ACTUAL TRADING RESULTS. THERE ARE NUMEROUS OTHER FACTORS RELATED TO THE MARKETS IN GENERAL OR TO THE IMPLEMENTATION OF ANY SPECIFIC TRADING PROGRAM WHICH CANNOT BE FULLY ACCOUNTED FOR IN THE PREPARATION OF HYPOTHETICAL PERFORMANCE RESULTS AND ALL OF WHICH CAN ADVERSELY AFFECT ACTUAL TRADING RESULTS.