You might be wondering… why does trend-following/TAA work in the first place?
If you’ve ever heard of the efficient market hypothesis, then you’re certainly skeptical of the benefits of trend-following. What the efficient market hypothesis (EMH) taught is that you should NOT expect to do better than the market itself.
EMH is most closely associated with Eugene Fama’s research from the 1950s and 1960s. This research assumed that humans are rational. And if there were any market abnormal profits to be had, investors would quickly arbitrage it away.
This all changed in the 1980s when Daniel Kahneman and Amos Tverskey opened our eyes to behavioral research. The best resource on behavioral finance remains Thinking Fast and Slow by Kahneman. However, I found The Undoing Project more enjoyable, and it gave me 80% of what I needed to know.
What behavioral research found is that all humans are irrational. Yes, all humans. Not just Brody and Kaden on spaghetti nights.
This irrational behavior can be used to explain why trend-following works in markets.
Here are some examples:
- Recency bias drives decisions – we tend to project the recent past into the future causing confidence and overconfidence
- The anchoring effect creates a slow reaction to new information – we don’t want to change
- This underreaction creates a catch-up effect and/or overreaction, which drives our…
- Herd instinct or Bandwagon effect – Humans are driven by fear and greed
- Buying begets more buying
- Selling begets more selling
- Investment institutions are incentivized to chase performance in rising markets and de-risk in declining markets, which reinforces trends that are already moving in the same direction
- The diffusion of information is inconsistent across the market causing positive feedback loops that contribute to price trends
- Not all traders discount information the same way or at the same time.
- Example: One investor’s interpretation of inflation may be reviewed as transitory while the next suggests persistence
- Example: One group of trader’s “pricing in” a Fed Reserve interest rate pivot while another doesn’t
- The endowment effect causes to sell winners too soon and hold losers for too long
As long as humans remain irrational, one could expect trends to continue.
Even Eugene Fama, the author the Efficient Market Hypothesis, accepted the trend-following factor, momentum as a true market anomaly. He stated that “momentum is the premier market anomaly. Stocks with low returns over the past year tend to have low returns in the next few months, and stocks with past returns tend to have high future returns.” This is important because this is the guy who built his career and reputation on the fact that markets were efficient (aka one can’t do better than the market)!
If you’re concerned about the persistence of trend-following over the long term, I get it. Our job as investors is to prepare for the unknowable future, not to predict it.
However, if you’re like me, you can take comfort in knowing that changing human behavior is unlikely, which is good news for the longevity of trend-following.
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