The Law of Inertia in Trend Following
The market moves in orderly and predictable trends. Overtrading and anxiety when trading can be avoided by implementing the Law of Inertia to your trend following mindset.
- Matthias Hagemann
Updated October 20th 2020
I pondered a long time about why focusing on larger trends was difficult for me in the beginning. Like anyone starting from scratch, I fell into a trader’s death spiral of leveraged trading and anxious scalping. Large market forces were at play but were ignored in the heat of the moment. It didn’t feel right.
Then it dawned on me. I wasn’t like that before I started trading actively. I was calm and could think without anxiety. Problems accumulated after I subscribed to intraday charts that weren’t static images, but moved.
When I performed my coup with the Shanghai Composite, it was precisely the lack of real-time feedback that allowed me to think clearly. I had no access to a data feed for the Chinese stock market, it would be closed by the time I woke up, and a hasty order could not be filled until the morning after. It was freedom from having to constantly make a decision.
Mental bandwidth widened simply by doing less.
The answer to why I overtraded had to be too easy access to real-time feedback. I went back to the drawing board and hatched up a philosophy that had been lingering in my head.
Why Markets Move Slowly
Firstly, you have to get accustomed to the idea that markets don’t move fast at all (when you look at real-time data day in and day out, you obviously have a different opinion now). Forget the 15-minute chart or whatever intraday time frame. Secondly, you zoom out to the weekly chart, even the monthly chart.
You will start to see the forest for the trees.
In his 1954 work New Blueprints for Gains in Stocks and Grains, William Dunnigan articulated his insights on the philosophy behind trend following:
We think that “forecasting” should be thought of in the light of measuring the direction of today’s trend and then turning to the Law of Inertia (momentum) for assurance that probabilities favor the continuation of that trend for an unknown period of time into the future.
It is possible to profit from trends as they unfold day after day, week after week. We just have to ‘steer our ship in the direction of the prevailing wind’.
In doing this we no longer need to entertain predictions for whether the S&P 500 is going to 1,000 or 10,000. Predictions simply don’t matter. When the prevailing wind changes, we steer our ship accordingly.
Markets Move Like a Freight Train
Imagine a freight train’s acceleration and deceleration according to the Law of Inertia (also known as Newton’s First Law of Motion): Once a resting locomotive and its fully loaded wagons begin to move, it becomes excruciatingly hard to reverse the direction. Everything is unbearably slow initially. Then it gains momentum and it will keep on doing what it’s doing. To halt the train at this stage, an extreme amount of force needs to be employed. You cannot have the train move forward then backward, from one instance to another. It’s physically not possible.
Plotting the train’s velocity on a time scale, you would see a logarithmic curve that looks like this:
It closely resembles the four types of regression curves I introduced in my previous post.
Monetary commitments have a similar dynamic because countless market participants are involved who need to observe, analyze, and perhaps adjust each individual position — a process which obviously takes a long time to unwind. That’s why regression curves work so well. They visually represent the proverbial freight train’s trajectory.
A Collective Conscience of the Market
One market participant’s trade can influence the price which in turn can influence another market participant’s trade, similar to how a train’s connected wagons push and pull each other. This idea resembles George Soros’s Principle of Reflexivity. His theory argues that a feedback loop exists in which investors’ perceptions affect economic fundamentals, which in turn changes investor perception.
All these individuals make up a collective conscience of the market. As a consequence, stock prices ebb and flow rather than jolt all over the place.
The collective conscience will undeniably affect your positions. The crash or recession you were too young to experience still impacts the outlook and decisions of other, older market participants who have as much marginal influence as you do.
I enjoyed a thought posted by Michael Bigger of Bigger Capital:
The market is energy. On any particular day, think about the energy needed in order to move one unit of capital (a security) by a distance y (unit of stock price). Think about all the energy required to move all the capital market securities in the U.S. market at any given point in time. The amount of energy required to accomplish this transition must be substantial, almost infinite.
Despite high-frequency trading by sophisticated algorithms playing an increasing role on Wall Street, they have not changed a single thing in how trends evolve.
Your First-Mover’s Advantage
A similar concept applies to large crowds such as armies. Here is an excerpt from The Book of Five Rings by Miyamoto Musashi:
The large scale is easy to see; the small scale is hard to see. To be specific, it is impossible to reverse the direction of a large group of people all at once, while the small scale is hard to know because in the case of an individual there is just one will involved and changes can be made quickly. This should be given careful consideration.
Musashi’s eloquent illustration for the battlefield can be transcribed for the marketplace in which many participants form a unit heading in the same direction.
You can reverse your position in a snap. You can be at the forefront of a new trend if you use your small size to your advantage by flipping your position with a click of a button. Large, institutional funds don’t have this advantage. That’s why being non-consensus and right is the only way to build extraordinary wealth.
If you are hyperactive or indecisive, it can quickly become a disadvantage. Just like how subscribing to a real-time data feed ruined my emotions.
It is crucial to be particularly attentive at market junctures and be ready once a new trend is shaping up. Position yourself and let the market’s collective conscience guided by the Law of Inertia take care of the rest. This is your edge.