What Is Trend Following?

The simple tools we use are a chart and a simple moving average. By looking at a chart of the stock market and applying a simple moving average (moving average) to that chart, we let the market tell us what the current trend is.

When Dick Fabian developed his plan, most of the data, and charts, he had access to use the 39 week moving average (WMA). At some point, Dick made the move from the 39WMA to the 200 day moving average (DMA).

Just to clarify, the 39 WMA would be about the same as the 195 DMA (39 week x 5 days=195).

The 200 DMA would be about the same as the 40 WMA (200 days / 5 days=40).

Although not mathematically identical, for the purpose of our discussion, the 200DMA and the 40WMA are considered the same.

I prefer to look at the market on a weekly basis so I use the 40WMA for BUY and SELL signals. The weekend generally gives more time to look things over. If you prefer to use the 200DMA go right ahead. Looking at the market on a weekly basis tends to smooth out some of the back and forth movement and can also help to cut down on more frequent trading.

Click on the two links at the bottom of this page to see the difference between WMA & DMA.

So, when we look at a chart of the market, with our moving average added, if the value is currently above the moving average, that is an indication the market is in an up trend.

If the market value is currently below the moving average, that is an indication the market is in a downtrend.

We then use the points when the market value crosses above and below the moving average to generate buy and sell signals. This is how the market tells us what to do.

When the market value moves above the moving average, that's a BUY signal.

When the market value moves below the moving average, that's a SELL signal.

That's the basis of this plan. Those are the only two specific rules that must be followed. When to buy and when to sell. There are other steps we will cover later. Did I say it was simple?

If you look back at a broad market index, like the Wilshire 5000, from January 2000 to January 2004 you can clearly see when, the spring of 2000, it would have been a good time to move out of the market and into the safety of a money market fund. You could also see when it would have been a good time, the spring of 2003, to move back into the market.

(If you go to BigCharts.com and use the symbol TMWX with a 40WMA on a weekly chart or 200DMA on a daily chart, you can see what I'm talking about)

Check out the Tools page for links to various charting sites.

OK, so now the market has told us it's time to BUY, now what. We will talk about the type of investment choices later. The specific investment we choose is really secondary to the fact that the market trend has changed. That's why Dick Fabian says, "the investor is more important than the investment". What's really important is that we make the changes when the market tells us.

A point to remember here is that when we invest, we can have four possible outcomes. The first three are ok. The last is not!

1) A BIG GAIN.

2) a small gain.

3) a small loss.

4) A BIG LOSS.

We can deal with the first three. We don't want to deal with the last one!

This is really, really important when the market flashes that dirty little four letter word...SELL. This is when you, the investor, are most likely to ignore what the market is saying. You will want to stay in your comfort zone. You will listen to the "noise" out there. The magazines, talking heads on TV and so-called experts will try to convince you that you are in for the long haul. That the market always comes back and that you should just hold your positions and maybe even add to them. At that point, it would be a good idea to get out your chart of the market from 2000 to 2003 and take a very good look at it. Remember that you won't be able to invest for the long term if you loose all of your money in the short term.

The idea then becomes taking advantage of the power of compound growth to capture better than average returns. We hope for overall higher returns because we have not suffered large losses because we continued to hold investments as the market has been going down. Since we have preserved our capitol during the down trend, we can take advantage of the new up trend for growth and not just having to get back to where we were.