To some traders trend following looks like an offshoot of momentum investing. But the truth is, although they appear similar, in reality, they are poles apart.
Both approaches are disciplined forms of investing with a focus on price, a focus on trends, and a focus on when to exit. Both buy on the upswing, and sell on the downswing. Both cut their losses. And that is where the similarities end.
Momentum investing relies on predictive fundamental analysis: Momentum-style investing relies on earnings momentum in selecting and shedding investments. It?s a bottom-up style that looks at fundamentals first and foremost, concentrating on sales, earnings, etc. By looking at fundamentals first, momentum investors trip up. Predicting and timing buys, sells and shorts from changes in the fundamentals, whether these changes are interpreted as positive or negative don’t pan out. Crystal-ball forecasts never do. The arbitrary periods momentum investors use to predict earnings, sales and all other fundamental nonsense don?t guarantee what an investment will do tomorrow — whether these periods are measured in years, quarters, months, days, or even minutes.
Momentum investing looks for earnings estimates: Why even bother with earnings at all? All of the statistics, all the increases and decreases from the prior quarter and year, all the estimates from analysts, constantly revised, and all the whisper numbers are simply relative. They are numbers that can be manipulated over and over again to mean anything one wants them to mean. You?ll hear one set from a company?s CFO, and a different set from competing analysts at big brokerage. The media reports all of them and then the talking heads chime in with their spin. Trying to obtain the truth about earnings is like playing the old telephone game where a chain of people whisper a sentence to the person next to them and it comes out something completely different at the end of the game.
And real earnings estimates don’t exist: There is little truth in the earnings numbers you hear about. The estimates are padded to keep investor expectations high–or conversely, low-balled to keep investor expectations low. Even when the real earnings number comes out, it is revised again a month, a quarter or a year later. Real earnings numbers are like real economic data. Chances are the data has been revised again and again to reflect whatever the current administration wants you to believe about the economy during that particular period of time. The data is usually negative for the opposing party and positive for the party in power, and therefore, no different from a company?s earnings statements. Once again, if the price is the key, why bother with all the rest?
Momentum investing Involves mind games: Investors–both individual and institutional–have gotten so wise to the unreality of earnings estimates that they often take up for down and down for up, so that a game of double or even triple reverse psychology ensues. Using fundamentals, investors play mind games trying to discern what?s really going on. Mind games don?t generally make people any money, although if you want to play them, be our guest. However, if you want to make money and keep on making money, avoid the mind games and figure out what you must be focusing your attention on ? which is price.
Trend Followers look at price: That’s the major difference between the two approaches. Trend Followers ignore predictions, whatever they are based on. Year-over-year or quarter-over-quarter changes in sales and earnings are meaningless to a trend follower since these fundamentals have no bearing on what a price will do tomorrow. How different is that difference? It makes all the difference. Momentum-style portfolios and investors have tanked while Trend Followers over the long haul outperform.
Trend Followers cultivate patience: Unlike momentum investors who are constantly moving, buying and selling in the market every day, Trend Followers can wait months, even years, before making a move at all. They don?t even need to know the name of the market to trade it. They look for the price trend and buy long on the upswings, and sell short on the downswings.
Trend Followers focus on size: While momentum investors concern themselves with fundamentals, Trend Followers concern themselves with the size of their trades. They manage their capital for every move. In so doing, they limit risk when the trend changes. Their discipline keeps their increases exponential, while their decreases gently taper off. Like blackjack, the size of the bet matters. Tailoring the size of the bet to the trend–up with up-trends, down with downtrends–keeps the Trend Follower in the game, with capital to invest tomorrow.
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