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Sticking with your winners, even the overvalued ones, appears to be the best strategy. From Moneyweb.

Harnessing the power of trends in the stock market is called momentum investing. Warren Buffett, much as he might resist the label, is a momentum investor. Image: AdobeStock

A survey of six major brokers reveals a stark reality: 71-80% of their clients lose money. Nearly 80% of those using quantitative strategies face losses, and among active day traders, up to 95% lose money.

These are the frightful realities that face any investor looking for an edge in the market.

Listen/read: True value investing allows a trusted share its ups and downs

“Clearly, investors need a more disciplined, strategic approach to managing their portfolios. Trend following could be the best strategy to fit the bill,” says Alex Krainer in his book, Trend Following Bible.

“After more than 25 years as a market analyst, researcher, trader and hedge fund manager, I have few certainties about investing apart from these two:

  • “That market trends are the most powerful drivers of investment performance;
  • “That trend following is by far the most profitable strategy of long-term investing.”

It’s interesting to note that the one group of investors with astonishing predictive powers is US senators, who outperformed equity markets by 12 percentage points a year over eight years, as measured by Georgia State University researcher Alan Ziobrowski.

That performance was better even than corporate insiders, who beat the markets by 5%, while ordinary investors underperformed by 1.4%.

What insights, wondered Ziobrowski, did US senators possess that gifted them such extraordinary investment success?

It’s long known that a stint in US politics is a speedway to the millionaire class, given its privileged access to insider information.

Market consensus is not always right

Those who do not have inside market information must rely on analysts and ‘market consensus’.

But there are many instances of market consensus getting it dead wrong. The 1990s oil price collapse to around $10 a barrel is a case in point: there was a growing belief that the world was facing a ‘peak oil’ crisis when demand would far outstrip supply. The global economy was in full-throated roar, and investment was being fire-hosed into telecoms and IT rather than new oil production. Analysts at the time saw it as inevitable that demand for oil would explode, pushing prices higher. Instead, oil prices more than halved between 1997 and 1998.

Analysts believed the market had simply got it wrong about oil or was being manipulated. Here was a case of a trend continuing more powerfully and for longer than common sense would dictate.

ReadFrom boring to billionaire … 

Bitcoin – the best-performing asset of the last decade – is another example of a trend that seemed to defy all expectations. The same applies to the S&P 500, Nasdaq, and the shares of companies like Amazon, Apple, Alphabet, Tesla and Microsoft.

Trend following – or the study of charts – means discarding the fundamental narratives believed to drive price action, argues Krainer. Trying to fight these trends is futile and likely to result in loss. Part of the reason for this is the bias baked into analysts’ narratives, which rely on the energy industry, investment bank reports, or government agencies, all of which tend towards exuberance. Add to this the frequently alarmist research coming out of academic institutions, framed by ideological objections to fossil fuels or nuclear energy.

The investor has to wade through this miasma of potential disinformation.

“The arithmetic of government statistics – jobs, growth and inflation – is distorted and dishonest almost beyond measure,” said fund manager Paul Singer.

Research teams produce professional and credible-looking reports with neatly tabulated figures and compelling-looking charts, says Krainer, but they often lead to rather different conclusions. “Between the lines, it is not difficult to discern the root of each group’s bias. The oil industry and their bankers want to attract investment capital.”

The folly of forecasting

Forecasting is another folly that tends towards groupthink, with the best economists in the world completely blindsided by the economic slumps of the early 2000s and the follow-up financial crisis of 2008-9, as shown by the US Federal Reserve Bank of Philadelphia’s Livingston Survey (which comes out twice a year).

Virtually no one saw any iceberg ahead when making their growth forecasts in these crucial years.

Oil price forecasts have likewise been all over the place, as the US dollar strength was shown over the past several decades to have had the strongest influence on the commodity price – not supply and demand fundamentals.

Market forecasting is about as useful as tossing a coin. A study by the CXO Advisory Group examined more than 6 500 stock market forecasts from 2005 to 2012 made by 68 experts – and found that just 46.9% were accurate. As computerised forecasting models have become more complex and require greater numbers of data inputs, small variances in any one of the inputs can result in large differences in the final results.

SA has a long and sordid history of fanciful economic forecasts, with 80% of National Treasury forecasts of economic growth for budgetary purposes falling short of the mark.

Read: A decade of budgetary whoppers

For the past century, stock markets have mainly trended upward, with occasional crashes and corrections. This made it possible for investors to generate positive returns, even if investing passively.

Decades of research led to the conclusion that expertise in the form of active fund managers, armed with degrees and volumes of data, is unable to consistently beat the market.

This has been confirmed in several studies. One such study by investment advisory firm Daniels and Alldredge found that only 9% of 658 global equity funds beat the QGS index, with the performance span ranging from 14% below the index to 6% above. In other words, there is a much higher likelihood of poor performance and a limited chance of outperformance.

One of the great underreported skeletons of fund management is the huge cost of developing quantitative systems that don’t work.

A case in point is the 1998 collapse of hedge fund LTCM, led by Nobel laureates Robert Merton and Myron Scholes.

Another is the 2012 wipeout of $440 million at Knight Capital in just 30 minutes due to a faulty trading algorithm. To be fair, there are algorithms that perform as expected, but success has often come at a huge cost.

News is the enemy

Star traders like George Soros acolyte Victor Niederhoffer, who adorned the covers of business magazines before he got wiped out in the 1997 stock market crash, are a rarity. Warren Buffett, much as he might resist the label, is a momentum investor.

There is a tendency for traders to immerse themselves in news that either supports their trading decisions or injects doubt into them.

An interesting study by Paul Andreassen at the Massachusetts Institute of Technology divided students into two groups.

Each was free to buy and sell stocks as they saw fit, but one group had constant access to market news, while the other group was restricted to monitoring their portfolio performance only through changes in stock prices. The experiment showed that students who got no financial news at all earned double the returns of those who frequently checked the news. The lesson here appears to be that news is the enemy of good investing.

Another study by Daniel Kahneman and Amos Tversky discovered that we tend to be highly risk-averse about gains, and risk-tolerant about losses. This manifests in traders exiting winning trades too early and hanging on to losing trades too long.

Loss aversion can cause traders to lose money even when their judgment is correct. Unless their decisions are executed with flawless timing, traders may have to endure unrealised losses on their positions for a period of time, straining their emotions and putting their conviction to trial.

Many traders are right about their market analysis but wrong about timing. A case in point is Stanley Druckenmiller, another George Soros protégé, who in 1999 correctly read the looming bust in tech stocks and started shorting them. What he did not anticipate was the huge “melt-up” in tech stocks in the early 2000s. He blinked, covered his shorts, and joined the bulls on the upside. A short while later, 75% of the stocks he originally shorted ended up at zero. Druckenmiller ended up making a huge loss on what was a correct trading call.

Trend following

Krainer came to the conclusion that there is far more to simple observation of charts than most would admit.

John J Murphy’s Technical Analysis of the Financial Markets details case after case of prices remaining range-bound within defined trendlines for months or even years. Technical analysis – or the study of charts – does not attempt to answer why this appears to be so. It merely records that it happens.

Like the Efficient Market Hypothesis, technical analysis also assumes that all the information that’s known and relevant to the value of some asset is already reflected in its price.

Many academics discount charting as a pseudo-science, as suggested by the Random Walk theory, whose proponents argue that prices are driven by random and unpredictable future events. Chart studying is no better than tossing a coin, they say.

Harnessing the power of trends in the stock market is called momentum investing, where trends in liquid stocks are observed and then held for as long as they perform. A clear example of this is Tesla, which any rational analysis would suggest would never reach the lofty heights of $407 in 2021 before reversing the trend.

ReadOutperforming fund’s momentum strategy pays off

To test the momentum investment strategy, researchers Elroy Dimson, Paul Marsh and Mike Staunton from the London Business School analysed nearly 110 years of stock market data.

They constructed investment portfolios by selecting 20 top-performing stocks in the previous 12 months from among the UK’s 100 largest publicly traded firms and compared their performance to portfolios of 20 worst performers, recalculating the allocations every month. They found that the previous year’s lowest-performing stocks would have turned £1 invested in 1900 into £49 by 2009. By contrast, the previous year’s top-performing quintile of stocks would have turned £1 into £2.3 million, which reflects a staggering 10.3% difference in the compound annual rate of return.

Expressed differently, sticking with the winners, however illogical that may seem, is by far the best investment strategy.

Value investors such as Benjamin Graham and Warren Buffett have made such outsized returns by holding on to their best-performing investments, even though their rational analysis told them they were overpriced from the get-go – in other words, by following the momentum.