Trend following, sometimes known as momentum investing and other names, is an important tool for many investors. Few investors use only trend following to invest successfully, but it is a component of the toolbox used by many investors. This article goes into some detail about the history of trend following, the research supporting its use, why it works, and different types of trend following strategies.
The driving theory behind trend following is that investor (mis-)behavior causes the emergence of trends. When new information enters the market, investors underreact due to an anchoring bias that causes them to overweight prior information. As price begins to drift towards fair value, herding takes over and causes investors to overreact. This under and subsequent over-reaction is what causes a trend to emerge.
While somewhat contradictory to the notion that investors should not “chase performance” or “time markets,” evidence suggests that when systematically applied, trend following approaches can create a potentially significant return premium and potentially help investors avoid significant losses.