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Trend-Following Can Cut Risk (Part 1)

Bad performance tends to cluster.

Alex Bryan 27.06.2019

Over the long haul, the stock market has been a great investment, and it will likely continue to be. But its path is far from smooth. At times, it can be downright scary. Gut-wrenching volatility and ominous headlines can cause even seasoned investors to abandon stocks, which can derail a well-thought-out investment plan. That's why it's important to plan for the market's inevitable downturns before they happen.
The most effective way to reduce investment risk is to adopt a more conservative asset allocation. But many investors have a more aggressive asset allocation than they should (given their risk tolerance) because the stock market's returns are too tempting to give up, and it's easy to overestimate comfort with risk in an extended bull market.

A disciplined trend-following strategy can help investors who bite off more risk than they can chew. Trend-following is a momentum strategy that can be used to time exposure to an investment, based on the idea that an investment's (recent) past returns can help predict its (near-term) future returns. For example, a simple trend-following strategy may hold a stock index fund when its return over the past year is positive and sell it when its return is negative.

Trend-following can help cut risk while capturing most of the market's returns. That seems too good to be true, particularly for a market-timing strategy, but it has been undeniably effective.

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About Author

Alex Bryan

Alex Bryan  Alex Bryan, CFA is the Director of Passive Fund Research with Morningstar.

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