Trend following using exchange traded funds (ETFs) has a host of advantages, the primary one being that it helps you leave your emotions at the door. Emotional decision-making has been the downfall of many a portfolio. But not everyone is on board with the strategy.
Trend following is a strategy in which investors use trend lines to determine when they’re in and out of the markets. The strategy enables entry on potential long-term uptrends while limiting downside risk.
As asset values soar, remarks Kent Grealish, CFP and a partner in Quacera, a registered investment advisory firm in San Bruno, CA, for IndexUniverse, the potential for future profits diminish and risk rises. Grealish believes that it is prudent to progressively sell into an extend rally and slowly reduce exposure to a major correction. However, the strategy, though beneficial in reducing market risk, may increase opportunity risk, which increases the likelihood of regretting one’s decision to sell if the rally continues. [Do you have a stop loss?]
Grealish urges investors to engage in a disciplined asset allocation strategy to help take out the emotions in investing. An increase in value of an asset class will put the allocation out of equilibrium and require selling a part of the appreciated asset to balance out a portfolio.
Another option Grealish suggests is to become a “fully invested bear.” Believing that the current rally will continue, market strategists and many others have remained fully invested, but these are the same people who have also stated that things could “end badly.” This situation suggests that the investors are either willing to pay the consequences or expect to know when to sell, which is highly unlikely. [5 tips for getting started.]
Asset allocation doesn’t require much discipline beyond periodically rebalancing, which makes it a good strategy if you’re a hands-off kind of investor. But asset allocation does not protect you from bear markets – you have to tough those out and the last decade hasn’t been particularly kind. [What to avoid when investing in ETFs.]
As people get older, their earning years fade into the distance and it becomes increasingly important to protect what’s left of your nest egg. If you don’t have a strategy to sell in those times, many investors simply find a strategy of their own, and it tends to be an emotional one, further hurting their portfolios.
While it’s true that “nobody rings a bell at the top”, you can ring your own bell if you have a disciplined sell strategy. This will leave you with more money to invest when a new uptrend develops elsewhere.
If you do choose to stick with asset allocation, what are your rules for selling? What will you do with the cash? Be sure you know the answers to these questions.
Advisors and investors need simple, specific rules in order to follow an investment discipline over an extended period of time. We use the 200-day moving average strategy to determine when we’re in and when we’re out. When a position is above its 200-day, it’s a buy signal. When it drops below or 8% off the recent high, it’s a sell signal. [New year, new strategy.]
For more information on trend following, visit our trend following category.
Max Chen contributed to this article.