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Does Trend Following Work on Stocks?

Original post by Michael Wolfe of Demand Media

Investors take a number of different strategies in their eternal quest for returns. One of the simplest strategies is trending. Trending, sometimes call trend following, is the practice of identifying trends in the price of asset and making your investment based on the idea that this trend will continue. While effective sometimes, it can also leave the investor holding the bag.

Trends

When an investor is looking at an assets trend, he will examine how the price of the asset has changed over a set period of time. On the theory that this pattern will continue, he will then extrapolate out and make his investment based on this decision. In stocks, an upward trend will cause him to buy, while a downward trend will push him to sell or short the stock.

Sometimes It Works

Trending is not always ineffective. Very often, market sentiment will push a stock price in a particular direction. If the investor is able to identify this movement before it is complete -- and then is able to change his position before it reverses -- he can stand to make money. However, predicting a trend accurately with any reliability is exceedingly difficult.

Sometimes It Doesn't

Just because a stock is moving in one direction doesn't mean it will continue to do so. In fact, if a stock is identifiably moving in a particular direction, then it is very likely to fluctuate in the opposite direction. This is because if a stock increases in value, many investors will sell it off, while if the stock decreases, some investors may smell a bargain. Therefore, those buying stocks on trends may get badly burned.

Considerations

One of the difficulties of this strategy is that a stock can be trending in different directions depending on the timeline at which a person is looking. For example, a stock may be trending downward in the short term, but moving up for the year as a whole. Therefore, it would be hard for an investor to say which trend is dominant absent other information.

                   

References

  • "Investing For Dummies"; Eric Tyson; 2008

About the Author

Michael Wolfe has been writing and editing since 2005, with a background including both business and creative writing. He has worked as a reporter for a community newspaper in New York City and a federal policy newsletter in Washington, D.C. Wolfe holds a B.A. in art history and is a resident of Brooklyn, N.Y.

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