"Nature uses only the longest threads to weave her patterns, so that each small piece of her fabric reveals the organization of the entire tapestry." –Richard Feynman
One of the most common questions we hear about our systematic investing philosophy is the comparison of trend following to value investing. We welcome these questions. As trend followers and devotees of both Charlie Munger and Ed Seykota, we see common threads in contrasting investment philosophies.
The investment world, fraught with its dogmas and aphorisms, often leads financial advisors and investors down paths of polarization. It's not uncommon to find oneself nestled within a niche, abiding by a single investment doctrine. In fact, this behavior is commonplace among successful investors of all kinds.
However, when we adopt a wider perspective that’s informed by Munger's wisdom — "All successful investment involves trying to get into something that’s worth more than you’re paying" — the tapestry of investment strategies starts to reveal common threads.
Common Goals, Different Execution
While the paths of value investors and trend followers may diverge, at their core, both philosophies strive for a common goal: capital appreciation through repeatable decision-making.
Value investors are inspired by the likes of Warren Buffett and Munger. They seek undervalued opportunities by diving deep into financial statements, understanding business models, and weighing the sustainability of competitive advantages. They often adhere to Benjamin Graham's principle: "In the short run, the market is a voting machine, but in the long run, it is a weighing machine." This perspective encourages them to remain patient and look beyond short-term market fluctuations to realize long-term value.
On the other hand, trend followers stand on the shoulders of giants like Seykota and Bruce Kovner. They base their strategies on market behaviors. They believe in Jesse Livermore's adage: "There is only one side of the market and it is not the bull side or the bear side, but the right side." For them, market trends, driven by collective investor psychology, are the guiding principles. Instead of predicting the market's next move, they observe, adapt, and ride the prevailing trend.
Margin of Safety is Universal
The margin of safety concept is paramount in value investing. Value investors purchase an asset substantially below its intrinsic value, allowing a cushion to absorb miscalculations or market downturns. At the core, it’s about protecting the downside.
Trend followers, despite willingly distancing themselves from company fundamentals, also encapsulate a form of a margin of safety by delineating clear exit strategies. They may establish a predefined selling point, or stop-loss, as they seek to protect capital and help maintain a higher base from which to compound.
Thus, both philosophies embed mechanisms that seek to safeguard against substantial loss, albeit with different methodologies.
Timing: Before vs. After the Bottom
A key distinction between value investors and trend followers is their approach to entry timing.
Value investors, who are often contrarians, buy during high pessimism to capitalize on gaps between market price and intrinsic value. They buy when many are fearful, not to time the market but to find overlooked value.
Trend followers, however, ride long-term price movements. Instead of predicting bottoms, they react to current trends and enter when a clear pattern emerges. It's not about market timing but leveraging historical trends.
While value investors may buy before a market bottom and trend followers after, their average purchase prices could align.
The Wisdom in Avoiding Stupidity
Munger, with his incisive wisdom, often emphasizes the value of sidestepping folly over always aiming for brilliance. At one Berkshire Hathaway annual meeting, he was quoted as saying "It is remarkable how much long-term advantage people like us have gotten by trying to be consistently not stupid, instead of trying to be very intelligent." This perspective resonates deeply within the principles of both value investing and trend following.
When it comes to the foundational tenet of avoiding mistakes, the two philosophies share common ground:
- Behavioral Finance: Both value investors and trend followers maintain an intense awareness of market psychology. While value investors might look for opportunities where the market's emotional reactions have led to mispriced assets, trend followers ride the very waves of these emotions, seeking to capitalize on momentum created by collective investor sentiment.
- Discipline and Patience: Discipline in sticking to one’s strategy and the patience to wait for the right opportunities are hallmarks of both approaches. Whether it’s a value investor waiting for the market to recognize the intrinsic value of an undervalued asset or a trend follower waiting for a clear trend to emerge, both eschew hasty decisions in favor of calculated, patient moves.
- Risk Management: Both strategies emphasize the importance of protecting capital. Value investors do this by seeking a margin of safety in their investments by ensuring they're not paying more than what they believe an asset is worth. Trend followers, on the other hand, often employ stop-losses and other loss-mitigating strategies to ensure they exit a position if the market moves against them.
The More ‘Client Friendly’ Philosophy?
Understanding the similarities between trend following and value investing is more than just an academic exercise for Blueprint Investment Partners.
Trend following forms the basis of all our strategies, and it is the methodology and lens by which we see the world. We utilize trend as both a risk management tool and asset allocation engine, and we believe doing so provides the financial advisors who partner with us the highest probability of meeting the investment objectives of their clients over the long run.
In our view, trend following is significantly more “client friendly” than value investing because it can help keep investors in their seats by minimizing the risk of substantial declines in portfolio value and protecting against potential catastrophic losses. Moreover, because trend following uses a predictable, repeatable process, financial advisors and their clients know how to expect the portfolio to behave in various market environments.