Trend following as recognition cue

One of the great investment problems is learning to process all of the information that exists about the markets. There is information overload both from good facts and analysis and just plain noise from information that is useless. There clearly is a limit in the amount of information that can be stored and processed by any manager.

This overload problem is is what makes global macro investing especially difficult. There has to be continual review of all asset classes. The macro investor has to understand the US equity market as well as all other major markets and their relative value. The macro investor has to understand US bonds markets as well as bonds around the world. The macro investor also has to track currencies, commodities, and alternatives. In fact, this broad set of markets has to be continually tracked by any diversified investor. 

One solution to this information problem is just to hold a broad basket of asset classes and not worry about information overload. Portfolio diversification will protect from many asset specific risks. A higher level approach is to use some form of risk parity to further diversify risk under the assumption that there is too much information to process.

Another solution to the information overload problem is to use some rules of thumb or cues for determining what markets may have more potential for upside or downside. Trend-following as a filtering and smoothing mechanisms can serve as simple investment cue. Think of the most simple recognition cue and trends. There is a broad set of markets and one starts to do better than all the rest. This can be a cue that means something good is happening.

Systematic traders may use recognition cues through trends and stop with that as their only signal. The recognition of a trend could also call for a review of news or information to determine the reason for the trend. Of course, the news has already been announced and incorporated by the market. Processing of this information may take some time; however, there is evidence that once information flows start in one direction it may continue. For example, once monetary policy changes direction it usually stays in that new direction for some time.

Recognition cues are well known to be associated with memory retrieval. There is a cue which causes  us to recall a memory which then can start the process of information analysis. Unfortunately, using recognition cues to retrieve memories can have some problems, our recall or recollection may not be that good.

Keeping the recognition cue simple makes sense and is an effective way to make active investment decisions. If there is an absolute trend, there is a cue. If there is a relative trend, there is another cue. These cues can be used as simple substitute for tracking all the information that can be associated with all the diverse markets traded around the globe.