Trend following versus Buy-and-hold

“BUY and hold stocks” is probably the most popular investment strategy, preferred by retail investors.

First, it is simple. Second, it generally works as most countries’ stock indexes tend to go up in the exceptionally long term. Third, this strategy has been popularised by academics and investment firms. For instance, Jeremy Siegel’s Stocks for the Long Run is widely considered as the buy-and-hold bible.

In fact, the buy-and-hold investment strategy works very well in a super bull market. However, stocks do not go up forever as they are extremely cyclical. As such, investors will face a huge amount of volatility from time to time.

Let us take the case of the US S&P 500 index. From 1978 till 2023, it had quite some declines of about 20 per cent, including huge plunges of 36 per cent from August 1987 to October 1987, 51 per cent from March 2000 to October 2002, 58 per cent from October 2007 to March 2009, and 34 per cent in March 2020.

Faced with huge declines, investors often choose to sell low instead of the usual “buy low and sell high” since they cannot take the big plunges any longer. In short, not many investors have the tenacity to hold on to their stocks in the long term.

Is there an alternative to the “buy-and-hold” strategy that can help to mitigate severe market declines while offering equity-like returns?

In my opinion, I think retail investors can consider a simple “trend-following” strategy to help them navigate volatile markets. But what is “trend following”?

Trend following

It simply means buying when prices are moving higher and above the trend, and selling when prices are below the trend.

How do we define an uptrend and a downtrend?

Investors can use the 10-month simple moving average (SMA), which is an average of a market’s closing prices over a year, to define a trend. The 10-month simple moving average is used instead of the commonly known 200-day moving average to smooth out noises.

This is how it works: Investors buy in an uptrend when the monthly price is more than the 10-month SMA and sell and move to cash in in a downtrend when the monthly price is below it. Investors only need to update it once a month, say, the last day of the month.

By the way, the “trend following” criteria could be varied and many are proprietary. For instance, there is the Double Moving Average Crossover (for instance, the 50-day and 200-day moving average), Triple Moving Average Crossover, and Bollinger Bands. It is a market timing tool and academics usually call it “time series momentum”.

Importantly, “trend following” not only helps investors to stay and profit from the rising trend, but also to reduce losses, especially in a severe decline.

I did a backtest with this simple “trend-following” strategy on Vanguard’s 500 Index Investor Fund (VFINX) covering a period of over 45 years, from Jan 1978 to Aug 2023. Here are the results:

Here are some key observations:

The annualised return is 11.6 per cent for “buy-and-hold” and 10.6 per cent for “trend following”.

These returns look very favourable compared to the actual annualised return of the S&P 500 index, which is about 10 per cent in the long term.

The annualised return of buy-and-hold beat “trend following” by about one percentage point during this lengthy period.

The one-point difference between the two strategies may not seem a lot initially. However, small differences in compounding return in the long term matter a lot in the final sums achieved by investors.

A hypothetical $10,000 invested with a buy-and-hold strategy would be worth about $1.5 million over the period of 45-plus years, while the same $10,000 using the “trend-following” strategy would be worth $1 million.

In short, “trend following” may or may not enhance returns. It all depends on the time period and type of asset class. It is used mainly to reduce risks, and investors will have a less volatile portfolio as a result.

Here is the point: The maximum decline from top to bottom (drawdown) is minus 23.5 per cent with the “trend-following” strategy compared to minus 51.0 per cent with the buy-and-hold strategy.

In my opinion, a less volatile portfolio is crucial. A robust portfolio (single-asset or better still, multi-asset) should not only grow wealth in the long term but also ensure sufficient wealth in the interim. What if you need to sell some or all of the portfolio due to some emergencies in the interim?

Let’s say your portfolio is worth $1 million. A 50 per cent decline would mean your $1 million portfolio becomes worth half a million dollars and a decline of about 24 per cent would mean your portfolio is still worth about three-quarters of a million dollars. Which one is more palatable?

Also, not many investors will have the tenacity to face portfolio losses for an extended period of say, 10 to 20 years. “Trend following” can help to mitigate subpar returns during those lengthy periods.

At the end of the day, investors would need to choose between a higher level of wealth or a lower drawdown. Hard to choose? How about a 50-50 split of money allocated to both buy-and-hold and “trend following”?

The writer is a private investor. He was previously a researcher at an international business school in Europe, and an Asia-Pacific director at multinational corporations.