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 Trend Following: Generate Market Returns, Reduce Financial Anxiety Thumbnail

Trend Following: Generate Market Returns, Reduce Financial Anxiety

“My whole adult life has been one long crisis. Career crises, education debt, watching my I.R.A. lose a quarter to half of its value a couple of times, child care expenses, fraying social fabric, wage pressures, and above all, insecurity…", Dr. Caitlin Durham, 40, “This Isn’t What Millennial Middle Age Was Supposed to Look Like,” New York Times, Mar 14, 2023

Doctor Durham is not being overly dramatic. The S&P 500 index fell -47% peak-to-trough between 2000 and 2002; -54% between 2007 and 2009; and -34% in the, thankfully brief, Covid crash of 2020. Any S&P 500 index investor experienced those drawdowns. 

If you are young and have a sufficiently long-time horizon and do not need to draw on your portfolio for living expenses, you can afford to ignore the volatility, if you can stomach it, to get the long-term rewards. A buy and hold investor in the S&P 500 who managed to not touch their portfolio between the end of 1999 and the end of last week eventually earned 6.4% a year returns, for staying on the rollercoaster ride. Well below the long-term average of 10%, but still not too bad. 

Is there a better way to grow your wealth? Is there a way to capture stock market returns while avoiding the heartburn inducing drawdowns Dr. Durham identified above? We believe the answer is yes. One of the tools investors can use is trend following.

The graph below illustrates calendar year returns between 1990 and 2022. The 2022 calendar year return for the S&P 500 was -22%. For 2008 it was -37%.

Contrast this to the experience of investors pursuing a trend following strategy[1]. The return for 2001 would have been +2%. 2008 would have been -4%. Dr. Durham would have avoided those stressful years, at least in her IRA.

Over the long-run, from 1928 to 2022, we found that a trend follower did not have to materially sacrifice for the tremendous benefit of avoiding the market's nastiest drawdowns. A trend follower cut off the left tail outcomes that can destroy a portfolio, while preserving the right tail of good outcomes. A long-only S&P investor earned 8.5% per year, while a trend follower earned 8.3%, largely the same returns. However, the standard deviation for our long only investor was 19.4%, where our trend follower experienced a standard deviation of 13%. While the S&P 500 experienced a Sharpe ratio (return relative to risk) of 0.44, a trend follower generated a superior 0.64. If the goal of taking more risk is to get higher return, the trend follower did better. More importantly, the trend follower got the returns, without the anxiety. 

[1] The trends used are a proprietary mix utilized by Mulholalnd & Kuperstock Asset Management in risk-managed investment mandates.