Mistakes of Omission Are More Costly Than Bad Investments

Discussions about trend following typically emphasize seeking to protect against downside risk and capital preservation. However, with many equity markets near all-time highs, we think it’s important to explore other facets of this strategy. For example, we believe trend following’s ability to capture the upside is crucial, even if this attribute generally receives significantly less attention.

Building on our previous Co-Founders’ Note, we are taking a slightly different direction this month to give this attribute some attention.

Systematic Investing Can Help Capture The Upside

The art and science of trend following seems to remain a mystery to many financial professionals. However, it seems to be generally understood that tactical, systematic, trend-following processes may provide beneficial downside protection during times of extended crisis in financial markets.

We have the privilege to discuss our process with many financial advisors, and they generally either already know, or are quick to learn, that vacating weaker markets in a rules-based way can reduce the left side of the distribution where very bad things occur in markets. What appears to be less understood or underappreciated is the ability of trend following to capture upside in a way few investors have the courage to do on a consistent basis.

Take NVIDIA (ticker: NVDA) for example. We are beginning to lose count of the times we’ve heard some variation of the following statement. “Yeah, I bought it a while back and made a good return but got scared and sold it.”

As an illustration, let’s look at a basic and widely used trend-following strategy that involves buying an asset when its end-of-month price exceeds the 200-day exponential moving average (EMA). In the case of NVDA, this last occurred in January 2023.

Typically, trend following strategies don’t reduce exposure to an asset until certain pre-defined conditions are met. In this case, one might reduce exposure when the price of the asset class or position is below the 200-day EMA at month end, which was the case for most of 2022 for NVDA but hasn’t been the case since January 2023.

Now, let’s bring the buy and sell rules together to summarize our point. Using those simple trend-following rules would result in an investor:

• Being out of NVDA for most of 2022, when the stock experienced a roughly 50% decline
• Purchasing NVDA early in 2023
• Continuing to hold NVDA until the trend reverses

Trend followers don’t exit when financial services pundits say it’s time to sell, or because their gut tells them to do so. The exit timing comes only when the trend reverses – period. We and others believe this provides an opportunity to ride the coattails of well-performing positions for as long as possible.

Why Do We Ignore Missed Opportunities?

While human nature often calls us to examine the cost of making a choice that in hindsight we shouldn’t have made (i.e., sins of commission), people rarely go back and diligently evaluate the cost of not doing something they should have done (i.e., sins of omission). The latter is otherwise known as opportunity cost. 

Reflecting on opportunity cost can yield powerful lessons that inform future choices. However, failing to consider opportunity cost creates a bias, where future opportunities may be missed due to not fairly evaluating the whole historical picture and how alternative decision-making processes could have helped. 

For example, how many investors have let their memories of an investment that lost money stop them from reinvesting in a market – whether NVDA, the S&P 500, or otherwise – only to see that market make a sizable run without them?

Why do we ignore missed opportunities? Perhaps it is because what might have happened is opaque and fuzzy (i.e., requires work and self-knowledge). Perhaps a fear of finding the truth and experiencing dissatisfaction with what we discover causes us to avoid doing the research as a defense mechanism.

Unfortunately, we cannot give a simple answer for why we ignore missed opportunities, but what we can say is that, in our opinion, one of the most unheralded benefits of trend following is that it eliminates this blind spot and resulting bias. When a financial advisor and their clients embrace a systematic approach, they gain access to a fully developed plan to address any and all market scenarios. Are the results always perfect? No, not any more than anything else in this world, but the drive for perfection is often the enemy of achieving what is optimal or sufficient.

It reminds us of a saying that economist Milton Friedman often used. In short, he said that those who focus on equality at the cost of liberty will get neither, but those who focus on liberty over equality will get a large measure of both. As it relates to this month’s Note, we argue that those who favor perfect results over consistent returns will get neither, but those who favor consistency over perfection will get a large measure of both.

We think the hardest part of serving investors is keeping them on course. Three years can seem like an eternity in our instant-gratification culture, but it is no time at all in the grand scheme of most investors’ long-term goals. In our view, good strategies are built for a lifetime of investment possibilities, not three or even five years, let alone a calendar year. This conflict is a big obstacle to helping clients achieve their goals.

Fortunately, we continue to encounter financial advisors who understand this concept and embrace the challenge. For this we are eternally grateful. We will never be everyone’s cup of tea, but we are thankful we don’t have to be. We are happy to continue serving those who appreciate the consistency of a trend-following approach, and we will continue to search for more tribemates!