Understanding Momentum Investing and Trend Following

Two popular terms which often confuse investors are "trend following" and "momentum investing." Perhaps the most glaring commonality between these two is their blatant defiance of "buy and hold," the practice of selecting an investment and holding it indefinitely, believing that over time the market goes up, and therefore any investment will appreciate. Although the buy and hold approach has been touted for years by academics as the best method of investing, in reality it has its shortcomings, which are apparent in every Bear market.

Despite being the antithesis of buy and hold, both momentum investing and trend following strategies are predicated upon a disciplined investment approach that's designed to buy when the price of an issue is increasing and sell when the price is declining. Additionally, an exit strategy is normally incorporated to override the human tendency to hold losing positions much too long. Yet despite the distinct characteristics that these two terms share, in reality they are quite different.

What is Trend Following?

Trend following, in its most basic definition, is a systematic investment approach predicated upon buying and selling securities based on the sustained price movement of the issue. It's important to point out that trend followers don't predict the future price movement of a stock; rather they examine the issue using technical analysis to determine which direction, if any, the equity is currently moving. If a bullish trend is emerging, the trend follower will likely buy a position in the stock and hold it until the trend begins to weaken or change direction. If the equity exhibits a bearish trend, the trend follower can short the position, wait until the trend reverses, or merely find another issue.

But there's much more to being a successful trend follower than just selecting and buying securities. In fact, it can be argued that the most important aspect of trend following isn't when and what to buy, but rather when and what to sell! Often times, successful trend followers establish a "sell rule" that must be violated prior to selling the issue. These sell rules vary depending on the risk tolerance of each investor, but they typically consist of a trailing stop loss coupled with a confirming indicator. The overarching benefit of sell rules is that they provide a disciplined, mechanical methodology which the average investor should seriously consider implementing into his investment philosophy.

What is Momentum Investing?

Momentum investors are constantly searching for companies that are moving faster than the market. They believe substantial returns can be realized if they find, buy and hold onto those issues for as long as the price continues to go up. The old axiom, "if it isn't broken, don't fix it" illustrates the shared philosophy of momentum investors; those companies with the biggest price changes over the last few months are more likely to continue making substantial gains.
Fundamental analysis plays a much bigger role in momentum investing than it does in trend following. Momentum investors believe that buried within a company's earnings statement is the reason why the price has been increasing so dramatically. And if that underlying reason is uncovered, the opportunity presents itself to capitalize on that knowledge in the future.

In the case of trend following, investors want to identify where a security may be within the performance cycle. For example, how close to the 52-week high or low is the current market price and what is the short-term direction of the issue? For the momentum investor, the key criteria may be the relative strength of the security versus the market or more importantly the peer group of the particular security in question.

How to Develop a Successful Investment Strategy

Investors often ask why go through all the effort of actively managing a portfolio. The simple answer lies in the proven behaviors of economic cycles and sector rotation. Independent studies have proven that over time the largest percentage of a securities' price appreciation is driven by the industrial group within which the company is classified and not the performance of the individual company itself.

However, the real reason why investors should actively manage their portfolios is a concept called the "Time Value of Money," also known as "Compounding Rate of Growth." Many financial professionals will use the example of how a penny, if doubled every day, is worth over million after only 30 days. A very impressive and eye opening number given the small amount of initial capital outlay. What would happen if instead of doubling the penny every day, it were to grow by only 75%? The investment would be worth slightly over 5,000 rather than .7 million. Reducing the growth rate further to 50% and the end value is now ,917.51. A 25% growth rate for 30 days produces a value of only .08.

How does the concept of compounding growth translate into the selection of an investment strategy? Investors who actively manage their portfolios, either through trend following or momentum investing, have the ability to take modest gains and re-invest the profit in other trending securities over and over again. Buy and hold investors are not awarded this luxury since they rarely sell when the price is at the top. Rather, they buy a position when the price is low, ride the position all the way up in a bull market, and then watch as is loses value in a bear market. It's a very frustrating strategy, equally hard on the stomach as it is on the wallet.

Both strategies, trend following and momentum investing, demand a certain level of self-discipline in order to be successful. A portfolio risk-management system that uses the current market price and equity level of a position and some form of market volatility measurement is recommended. An example of such a system could be a proprietary market model focused on technical indicators, back tested over time, coupled with a volatility indicator. The system might employ either the Average Directional Movement Index (ADX/R), the CBOE Volatility Index (VIX) or the more traditional Advance Decline Line, Breadth or Volume indicators.

Taking Portfolio Risk Management Systems One Step Further

One noted management system authored by William O'Neil is CANSLIM. The CANSLIM approach combines both fundamental and technical analysis much like the Core Equity Portfolio available at QMA Investment Management, LLC. The weakness in the CANSLIM approach, along with many other similar systems, is that they stop short of providing a truly utilitarian system for the investor. The user ends up with a list of stocks, all of whom have meet the systems criteria, but no method for distinguishing between the good, the better and the best.

To address this problem, Alpha Advisor Service, LLC created the AAS Rating Score. This number is a time-weighted risk-adjusted alpha value used to rank each of the 1700 investments analyzed daily by AAS. The purpose of the AAS Rating Score is to create a level field to measure all investment alternatives. The highest AAS rated securities provide the greatest risk-adjusted return compared to the lowest rated securities. This approach is superior to other forms of alpha analysis since it is time-weighted, thereby identifying those stocks or funds that are providing greater returns for the risk taken. A tool of this caliber, which is available for any investor via the Alpha Advisor Service Newsletter, provides the means of not only developing a customized portfolio risk-management system, but also a disciplined method of buying and selling the securities within the portfolio.

Understanding The Real Estate Inflation Game

In the Fraser Valley's rapidly expanding real estate market there are several elements to consider. You are probably aware of the concept of inflation. But just to recap, inflation means that the increasing cost of buying a service or a product (tangible or intangible). This decreases your purchasing power. For example, an item that cost perhaps 10 dollars ten years ago, now cost 50. People in today's world that are on fixed incomes are very aware of their purchasing power of the Fraser Valley rental dollar.

This factor is very important to consider when renting your new home, apartment or townhouse in the lower mainland. The inflation rate in Canada varies at different times of the year and in different regions across the country. At one time Canada had what's known as double digit inflation. However, currently in the Abbotsford, Burnaby, Coquitlam, Surrey, Langley, New West and Richmond area, inflation has stayed relatively low.

Naturally, the appreciation of property value over time includes inflation factors. And historically, land appreciation value for residential homes has been between 4 and 5 percent greater then inflation rate. When you buy a home in the Fraser valley your buying a home with inflated dollars. That is, you are probably getting more money now in terms of salary increases to pay off lesser-value money when you took out that original mortgage. So your beating the system!

Renting in the Fraser Valley can often be a disadvantage given our appreciating real estate in Abbotsford and Vancouver. In fact Every city across the Fraser Valley has been hit by the real estate boom and has experienced some level of Appreciation. This includes Richmond real estate, Burnaby, Coquitlam, New West, White Rock, Mission, Maple Ridge, and all other major cities across the lower mainland. Appreciating simply means the increase in value of the property over time. It is the growth in value of your original capital investment.

The national average of appreciation with real estate in the Fraser Valley is 5%. However, real estate in the lower mainland has seen gains as much as 25%. It's important to understand that trends will go up and down. But with the 2010 Olympics coming up, interested rates staying under 10% and our economy the way it is, you'll notice the real estate market will continue to clime. The rent BC option has rapidly changed into a wealth building endeavor for any middle class investor.