Momentum investing has been with us for centuries. But it is only in the last several decades that data availability has allowed investors to become more intentional about using momentum as an investing strategy. Discarding the old Wall Street adage to ‘buy low and sell high, momentum investing promotes ‘buy high and sell higher.’
How do momentum investing strategies work
Momentum strategies focus on the idea that recent performance will persist. Stocks that outperformed will continue to do so in the short term. Academics and practitioners of momentum strategies typically look at previous 3-, 6-, or 12-month performance, buying the securities that have performed the best. The expectation is that those stocks will continue their outperformance.
Momentum investing takes advantage of several behavioral biases. Recency bias is the tendency for people to overweigh recent behavior into the future. We are slower to react to, or even overlook, new positive information. When the first reports are followed by additional positive reports, overreaction can result, pushing the stock further in the same direction (momentum). Confirmation bias is the tendency to seek information that supports your beliefs. When exhibited by investors, this looks like piling into winning stocks after they have risen, or selling out of losing stocks after they have fallen, because the original analysis was confirmed.
Is a momentum investing strategy effective
On paper, momentum is one of the most attractive market signals. Simulated portfolios following set rebalancing rules often reflect the success of faithfully pursuing momentum strategies. But a great deal is lost transferring those rules into actual practice.
A 2017 study by Research Affiliates, “Can Momentum be Saved,” shows how difficult it is to translate the theoretical to the real. They looked at every U.S. mutual fund with ‘momentum’ in the name and discovered that none had outperformed its benchmark since inception before accounting for fees and expenses. Not one. The two biggest hurdles to momentum investing include:
- Careless sell disciplines – letting winners run too long. Momentum’s profits accrue for months, not years, and then reverse course.
- Stale momentum – buying too late. Momentum has a finite life and you risk buying too late in the upward cycle. Fresh momentum is best, but it is incredibly difficult to tell the difference.
A third trap, high turnover, was removed after most brokerages drove trading costs down to zero in 2019.
Momentum investing entails two other risks. One, it typically works best in bull markets. The current bull market started 12 years ago in 2009, the duration of which explains the interest in, and volume of references to, momentum investing. In a declining bear market, there are far fewer momentum candidates from which to choose. Two, concentration risk can be material, with the stocks exhibiting the strongest momentum often part of the same one or two industries. If these industries face a setback, your entire strategy could come undone.
Stay focused on company fundamentals
Momentum exists in investing. It plays a role in the advance and decline of individual stock and their aggregate equity markets. But the ability to methodically apply appropriate rules and repeatedly harvest the gains from a momentum investing approach appear to be fleeting if they exist at all. It is wiser to remain focused on the underlying fundamentals of your portfolio companies and how your estimate of value compares to the market. On balance, your diligence and stock selection can bring its own momentum.