A Short History of Trend-Following and Momentum

A Century of Evidence on Trend-Following Investing by AQR published a report that used historical data on stocks, bonds, commodities, and currencies from 1880 to demonstrate that the strategy works across multiple asset classes for more than a century. The core idea behind trend-following is to buy assets that are in an uptrend and sell those in a downtrend.

This strategy appears to have been effective regardless of the asset class examined. AQR's research indicates that trend-following isn't a lucky pattern from recent decades, but rather a reliable approach spanning over a century of data.

Meb Faber's paper A Quantitative Approach to Tactical Asset Allocation published in 2007 would prove to be a significant moment in the world of investing. The paper presented a simple rule: if an asset's price is above its 10-month moving average, hold it; if below, move to cash. While the strategy isn't infallible due to potential false positives and whipsaws, it served as an effective insurance policy against severe stock market drawdowns.

The same rule was applied across various asset classes, including stocks, bonds, real estate, and commodities, since the early 1900s. Despite having false positives, it still delivered returns similar to a buy-and-hold strategy but with shallower drawdowns.

Wes Gray, another notable researcher, explored the behavioral benefits of trend-following strategies in his paper Avoiding the Big Drawdowns with Trend-Following Strategies. Gray combined two different trend signals—a 12-month absolute momentum rule and a moving average rule—and blended them 50/50 to diversify the signal. His findings showed improved returns alongside slightly reduced volatility and a significant improvement in maximum drawdowns.

The behavioral aspects of trend-following were emphasized by Wes Gray as well. He proposed the concept of dynamic risk aversion, highlighting that human beings' appetite for risk can change depending on their recent experiences. Trend-following can act as a "behavioral release valve," helping investors survive a big market crash scenario.

Moving on to momentum investing, Jegadeesh & Titman's 1993 paper Returns to Buying Winners and Selling Losers introduced the concept of momentum investing. The research demonstrated that stocks that performed well over the past 3-12 months tended to continue doing well over the subsequent 3-12 months, while stocks that underperformed in the past continued to underperform in the future.

This seemingly counterintuitive finding can be attributed to the herding behavior of investors. Once investors consider the role of herding behavior, momentum investing becomes a natural outcome of human nature. Momentum investing has been tested across different markets and asset classes, and the research indicates that it remains robust under various conditions.