Systematic Relative Strength

Marketwatch ran a rare mea culpa today. They had originally written an article in December 2008 to tell readers what investments they should buy for the coming year. Like all crystal balls, theirs was apparently cracked. Almost every prediction they made turned out to be incorrect. I give them a heap of credit for running the follow-up article to discuss what actually happened and what went wrong with their predictions.

Unfortunately, this wouldn’t be so nice if you still owned all of these investments. Investors love hearing predictions, but they often believe the forecasters have actual ability to predict. Imagine a scenario where you are flipping a coin. Only one of two outcomes are possible—heads or tails. I am the wise forecaster who will tell you which of the two you are about to flip. Do you believe that I have forecasting ability in this case?

Probably not, since you know that coin flips are random. Yet at least the forecaster has 50% odds of being correct in the coin flip scenario. With thousands of economic and stock market variables, I would venture to say that the real odds of a correct prediction in financial markets are far lower than 50%—it is a vastly more complex system.

Our investment methodology does not involve prediction. We follow the trend until it ends. When it ends, we find a new strong trend to get involved with. Sometimes following trends leads us to surprising places, and it certainly is not always profitable every quarter, but we don’t have to make guesses about what to do. Trend following is something that can be rigorously tested and we think that puts it more than a few steps ahead of trying to use a crystal ball.