| Two popular terms which often confuse investors | | | | actively managing a portfolio. The simple answer lies |
| are "trend following" and "momentum investing." | | | | in the proven behaviors of economic cycles and |
| Perhaps the most glaring commonality between | | | | sector rotation. Independent studies have proven |
| these two is their blatant defiance of "buy and hold," | | | | that over time the largest percentage of a securities' |
| the practice of selecting an investment and holding it | | | | price appreciation is driven by the industrial group |
| indefinitely, believing that over time the market goes | | | | within which the company is classified and not the |
| up, and therefore any investment will appreciate. | | | | performance of the individual company itself. |
| Although the buy and hold approach has been touted | | | | However, the real reason why investors should |
| for years by academics as the best method of | | | | actively manage their portfolios is a concept called |
| investing, in reality it has its shortcomings, which are | | | | the "Time Value of Money," also known as |
| apparent in every Bear market. | | | | "Compounding Rate of Growth." Many financial |
| Despite being the antithesis of buy and hold, both | | | | professionals will use the example of how a penny, if |
| momentum investing and trend following strategies | | | | doubled every day, is worth over $10 million after |
| are predicated upon a disciplined investment approach | | | | only 30 days. A very impressive and eye opening |
| that's designed to buy when the price of an issue is | | | | number given the small amount of initial capital outlay. |
| increasing and sell when the price is declining. | | | | What would happen if instead of doubling the penny |
| Additionally, an exit strategy is normally incorporated | | | | every day, it were to grow by only 75%? The |
| to override the human tendency to hold losing | | | | investment would be worth slightly over $195,000 |
| positions much too long. Yet despite the distinct | | | | rather than $10.7 million. Reducing the growth rate |
| characteristics that these two terms share, in reality | | | | further to 50% and the end value is now $1,917.51. A |
| they are quite different. | | | | 25% growth rate for 30 days produces a value of |
| What is Trend Following? | | | | only $8.08. |
| Trend following, in its most basic definition, is a | | | | How does the concept of compounding growth |
| systematic investment approach predicated upon | | | | translate into the selection of an investment |
| buying and selling securities based on the sustained | | | | strategy? Investors who actively manage their |
| price movement of the issue. It's important to point | | | | portfolios, either through trend following or |
| out that trend followers don't predict the future price | | | | momentum investing, have the ability to take modest |
| movement of a stock; rather they examine the issue | | | | gains and re-invest the profit in other trending |
| using technical analysis to determine which direction, if | | | | securities over and over again. Buy and hold investors |
| any, the equity is currently moving. If a bullish trend is | | | | are not awarded this luxury since they rarely sell |
| emerging, the trend follower will likely buy a position | | | | when the price is at the top. Rather, they buy a |
| in the stock and hold it until the trend begins to | | | | position when the price is low, ride the position all the |
| weaken or change direction. If the equity exhibits a | | | | way up in a bull market, and then watch as is loses |
| bearish trend, the trend follower can short the | | | | value in a bear market. It's a very frustrating |
| position, wait until the trend reverses, or merely find | | | | strategy, equally hard on the stomach as it is on the |
| another issue. | | | | wallet. |
| But there's much more to being a successful trend | | | | Both strategies, trend following and momentum |
| follower than just selecting and buying securities. In | | | | investing, demand a certain level of self-discipline in |
| fact, it can be argued that the most important | | | | order to be successful. A portfolio risk-management |
| aspect of trend following isn't when and what to | | | | system that uses the current market price and |
| buy, but rather when and what to sell! Often times, | | | | equity level of a position and some form of market |
| successful trend followers establish a "sell rule" that | | | | volatility measurement is recommended. An example |
| must be violated prior to selling the issue. These sell | | | | of such a system could be a proprietary market |
| rules vary depending on the risk tolerance of each | | | | model focused on technical indicators, back tested |
| investor, but they typically consist of a trailing stop | | | | over time, coupled with a volatility indicator. The |
| loss coupled with a confirming indicator. The | | | | system might employ either the Average Directional |
| overarching benefit of sell rules is that they provide a | | | | Movement Index (ADX/R), the CBOE Volatility Index |
| disciplined, mechanical methodology which the | | | | (VIX) or the more traditional Advance Decline Line, |
| average investor should seriously consider | | | | Breadth or Volume indicators. |
| implementing into his investment philosophy. | | | | Taking Portfolio Risk Management Systems One Step |
| What is Momentum Investing? | | | | Further |
| Momentum investors are constantly searching for | | | | One noted management system authored by William |
| companies that are moving faster than the market. | | | | O'Neil is CANSLIM. The CANSLIM approach combines |
| They believe substantial returns can be realized if | | | | both fundamental and technical analysis much like the |
| they find, buy and hold onto those issues for as long | | | | Core Equity Portfolio available at QMA Investment |
| as the price continues to go up. The old axiom, "if it | | | | Management, LLC. The weakness in the CANSLIM |
| isn't broken, don't fix it" illustrates the shared | | | | approach, along with many other similar systems, is |
| philosophy of momentum investors; those companies | | | | that they stop short of providing a truly utilitarian |
| with the biggest price changes over the last few | | | | system for the investor. The user ends up with a list |
| months are more likely to continue making substantial | | | | of stocks, all of whom have meet the systems |
| gains. | | | | criteria, but no method for distinguishing between the |
| Fundamental analysis plays a much bigger role in | | | | good, the better and the best. |
| momentum investing than it does in trend following. | | | | To address this problem, Alpha Advisor Service, LLC |
| Momentum investors believe that buried within a | | | | created the AAS Rating Score. This number is a |
| company's earnings statement is the reason why the | | | | time-weighted risk-adjusted alpha value used to rank |
| price has been increasing so dramatically. And if that | | | | each of the 1700 investments analyzed daily by AAS. |
| underlying reason is uncovered, the opportunity | | | | The purpose of the AAS Rating Score is to create a |
| presents itself to capitalize on that knowledge in the | | | | level field to measure all investment alternatives. The |
| future. | | | | highest AAS rated securities provide the greatest |
| In the case of trend following, investors want to | | | | risk-adjusted return compared to the lowest rated |
| identify where a security may be within the | | | | securities. This approach is superior to other forms of |
| performance cycle. For example, how close to the | | | | alpha analysis since it is time-weighted, thereby |
| 52-week high or low is the current market price and | | | | identifying those stocks or funds that are providing |
| what is the short-term direction of the issue? For the | | | | greater returns for the risk taken. A tool of this |
| momentum investor, the key criteria may be the | | | | caliber, which is available for any investor via the |
| relative strength of the security versus the market | | | | Alpha Advisor Service Newsletter, provides the |
| or more importantly the peer group of the particular | | | | means of not only developing a customized portfolio |
| security in question. | | | | risk-management system, but also a disciplined |
| How to Develop a Successful Investment Strategy | | | | method of buying and selling the securities within the |
| Investors often ask why go through all the effort of | | | | portfolio. |