Someone sent me a very interesting article called "The puzzling success of trend-following investment strategies" written by Gavyn Davies of the Financial Times. He writes about a speech titled Patience and Finance by Andrew Haldane who is an economist at the Bank of England, In addition to the article title including two words I like "trend following" Davies also says Haldane " writes some of the most interesting stuff available on the (mis)behaviour of the financial sector" so I thought it would be worth reading. Indeed, it was. The Bank of England economist figures out something I've known for a long time: directional price momentum tends to persist long enough for our trend-following system to exploit and capitalize on. Of course, trend following and momentum is my primary strategy along with active risk management and occasional hedging. Here is a part of what he said that I found most thought-provoking: (the highlights are mine)
This is an assessment of investment strategies which are based on momentum in asset prices, rather than long term economic fundamentals. Momentum wins the race hands down.
Andy Haldane conducts the following experiment. He estimates the results of an investment strategy in US equities which is based entirely on the past direction of the stockmarket. If the market rises in the period just ended, the strategy buys stocks for the next period, and vice versa. In other words, the strategy simply extrapolates the recent trend in the market. The result? According to Andy, if you had been wise enough to start this procedure with $1 in 1880, you would have consistently shifted in and out of stocks at the right times, and you would now possess over $50,000. Not bad for a strategy which could have been designed in a kindergarten.
Next, Andy tries an alternative strategy based on value. This calculates whether the stockmarket is fundamentally over or undervalued, and buys the market only when value gives a positive signal. The criterion for measuring value is the dividend discount model, first devised by Robert Shiller. If you had been clever enough to devise this measure of value investing in 1880, and had invested $1 at the time, the procedure would have left you with a portfolio now worth the princely sum of 11 cents.
I am sure that fundamentalists will argue that this particular value strategy is far too simple, and that other ways of using the Shiller p/e or alternative measures of value would produce much better results. That may be the case, but it does not detract from the fact that a very basic momentum-based technique seems to work very well indeed. And that should not be true if you believe in the efficiency of capital markets.
He goes on to say:
Much investigated, and frequently derided, the EMH has actually been very hard to disprove.
Efficient Market Hypothesis (EMH) has been very hard to disprove? I don't think so. It has been disproven. It was disproven by one of the first momentum studies: Jegadeesh and Titman (1993). It was disproven by Andrew Lo in his writing like A Non-Random Walk Down Wall Street. The waterfall crash of 2008 - 2009 is a clear example of in-efficiency. In fact, the belief in Efficient Market Hypothesis is one cause of the panic selling that created the waterfall crash. It was passive, buy and hold investors who held on and then panic at the lows. It was Alan Greenspan's belief in EMH that led to Fed actions over the years to allow banks to blow themselves up. If you are unaware of this fact, watch this.
The only reason one could say it hasn't is because its pallbearers continue to change the rules.If they are allowed to change the rules as they go it could never be disproven. In the mean time, at least a few of us are taking advantage of directional price trends.
Trends are caused by underreaction to new information. Directional price trends are explained by investor behavior. The market is the people who trade in it. Investors have a tendency to stick to their previous opinion even when new information comes along suggesting something has changed. Instead of changing their position quickly (as EMH suggests is the way it happens) investors react slowly. That's why we often see prices drift in one direction or another instead of a perfect stair step. That is, the market underreacts and overreacts to new information, so the market is not efficient as EMH incorrectly assumes. Many eoonomist, such as those who believe that markets are efficient, also believe that investors are rational. Neither of those beliefs are accurate in reality. The study of Behavioral Finance holds the key to understanding how markets really work.
