Sometimes it helps to go back to basics. If you are not completely satisfied with your investment process (or you don't have an investment process) here is the 1st in a series of 11 rules that will help you improve your returns and reduce your trading losses. In this series of posts, I will also explain the rationale behind each rule and highlight its significance.
Rule #1: Trade with the Prevailing Trend
There is a reason this is rule number one; it is the golden rule of trading. Do not trade against the prevailing trend. They will not teach you this in business school, but price changes are not random and the market is not efficient. The economy moves in long-term cycles of expansion and contraction and those cycles typically last several years.
During the expansion phase, companies invest in new projects, which require increased capital spending and additional employees, which also drive up wages. Increased employment and income lead to increased consumption and spending. Increased corporate and personal spending generates increased sales and higher earnings, which translates to rising equity prices. Earnings growth fuels more projects, more employment, more consumption, higher sales, and greater earnings, which generate self-sustaining expansions that last several years.
Unfortunately, all good things must come to an end, which applies to economic expansions as well. There are many factors that can trigger the end of an expansion: exogenous shocks, rising interest rates, central bank intervention to control inflation, and even unsustainable and irrational market bubbles. Contractions or recessions are also self-sustaining, but are typically much more severe than expansions and have shorter durations.
There are three principal types of directional strategies: trend-following, breakout, and reversal. From a practical perspective, it is relatively straightforward to construct simple trend-following strategies that capitalize on long-term market cycles. Trend-following strategies typically outperform buy-and-hold investing with far less risk and much lower drawdowns. In addition, the risk-return profile for breakout and reversal strategies can usually be improved by adding simple trend filters to ensure every trade is made in the direction of the prevailing trend.
Following this one simple rule will have a dramatic effect on your investment process.
For more in-depth information on trading with the prevailing trend, please revisit these earlier posts:
The Easiest Way to Identify Trends
The Secret Weapon of Technical Analysis
A More Efficient Relative Strength Indicator
Take the First Step Toward an Investment Process
Use Relative Strength to Identify Market Trends
Market Timing with Relative Strength Revisited
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