This post Turn Your Last Losing Trade into the Perfect Investment Strategy appeared first on Daily Reckoning.
Every investor knows that he’ll eventually have to deal with a losing trade. It’s an easy truth to admit. But it’s incredibly difficult to deal with losing money in the real world.
That’s why today I want to tell you about the trouble with trend following…
You’ve read all about the virtues of trend following on these pages. I’ve showed you just how lucrative trend following can be and why it beats buy-and-hold investing by a mile. I also revealed how little work it takes to be a profitable trend trader — less than five minutes of “work” a day.
But I don’t want you to think that this strategy is without any downside at all. You need the whole picture if you’re going to be a successful trend follower.
So what do you need to know to make consistent money with your trend following strategy?
Timing Is Everything
It’s true — timing is everything. By that, I mean that when you start a new trend following system has everything to do with how you feel about it. Think about it this way: As a trend follower, your system makes money by jumping on big trends in the market.
But what if there aren’t any big trends to take advantage of for a given week or month?
“It takes time to get a true picture of how well a trend following approach is going to work,” explains our own trend following maven Jonas Elmerraji. “That’s exactly why we run long-term performance backtests before ever putting a single dollar on the line. We have to be comfortable that our system beats the market and reduces risk, and that it has a high probability of continuing to do so in the future.”
Let me take you back to 2010. The markets were slugging through a sideways chop after posting a huge crash in 2008 and a huge move higher in 2009.
Most trend following systems made plenty of gains both those years (yes, 2008 was a good year for most trend followers), but they didn’t during the lateral price action in 2010. Folks who jumped on the system then would have a pretty bad representation of how well it worked.
For trend following to shine, you must give it time to sniff out the big trends.
Staying Mentally Tough
Nobody likes to lose. But if you’re a trend following trader, you better get used to it.
It’s not uncommon for trend followers to have more losing trades than winners. Many solid trend following systems post profits only about a third of the time. Yet they made huge gains over time. That works because the big trends that you hit a third of the time more than make up for the tiny losses you’re taking two-thirds of the time.
It takes a little bit more mental toughness to be a trend follower. You have to be willing to sell a few losers before you sell a big winner. But the beauty of this approach is that your system will tell you what names to buy and sell without any emotion involved. So if you can keep your long-term perspective, you’ll end up on top.
“When you think about trend following logically, that makes sense,” Jonas explains. “You’re looking to get in early on big trends, right? It follows that there will be times when the start of a new trend reverses and turns out to just be more sideways price action. A good trend system will tell you to sell those losers early enough that they won’t matter.”
You Won’t Be “Right”
Investors like a story. You probably have a friend or neighbor who loves a certain stock. Every time you see him, it’s a good bet that he’s going to let you know how much money he’s making on it (or if it’s down, he won’t bring it up at all).
That’s because investors like being right — it’s only natural to want to tell the world about your favorite investment and then get credit when it does exactly what you’d hoped. Who doesn’t want that ego boost?
But as a trend follower, you won’t get to be right about investments anymore.
Chances are that you won’t care what any given stock does. Instead, you’ll just care about the system you use.
“Yes, that does mean that you’ll be short on stock stories around the watering hole at work or on the green with your golf buddies,” Jonas concludes. “But who cares? Professional investors have a saying: There’s a difference between being right and making money.”
There have been plenty of investors who were right about a major market event but were positioned poorly enough to lose money anyway. Ultimately, you can’t retire on “being right.”
Trend following gives you the tools you need to make money. If you want the ego boost, stick to fishing.
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