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ETF Specialist

An Unconventional Risk-Management Tool

Trend-following may help reduce volatility and losses during market downturns.

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Fear and greed make most investors awful market-timers. It's easy to get excited about an investment after a period of good performance when valuations become stretched, only to turn around and dump it after the pain of a market downturn becomes too much to bear. This behavior is not entirely irrational. Large drawdowns at inopportune times can create a serious threat to investors' goals. It's sad to recall stories of investors who had to liquidate a significant portion of their investments in 2008 and 2009 to finance a large purchase or living expenses in retirement. The right time to plan for market downturns is before they happen. Trend-following may be an effective strategy to reduce the risk of large losses and volatility in a tax-sheltered account.

Trend-following is a rules-based market-timing strategy that attempts to take advantage of momentum in asset prices. Where traditional momentum strategies target assets that have recently outperformed their peers, trend-following is based on time series momentum. For instance, this strategy might buy assets that have exceeded their moving averages and sell those that have dropped below. It could work if investors under-react to new information, such as improving or deteriorating fundamentals, or pile into a trade once a trend is established.

Alex Bryan does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.