Momentum investors have multiple explanations for why stocks may move in the direction they do.
Value investing has been one of the most talked about ways to generate wealth in recent decades.
It’s what legendary investors like Warren Buffett and Charlie Munger swear by. That has made them one of the richest men in the world.
However, the investment style has fallen out of favor with investors since 2007. The poor performance was amplified after the March 2020 crash.
The liquidity injected by central banks around the world has boosted growth sectors such as technology. Value investing lost out to growth investing.
This raises some questions. Does value investing still work? Is the underperformance an anomaly?
Either way, investors need to be equipped to handle the new normal.
So how should one go about it? Is there another strategy that one can use?
Of the many investment strategies available, one comes to mind.
Investing momentum.
What is momentum investing?
Momentum investing is a strategy in which investors buy better performing securities and avoid or sell underperforming securities.
It is based on the premise that stocks that have risen will continue to rise or vice versa.
The goal is to work with the “momentum” by finding buying opportunities in an uptrend and then selling them when they start to lose steam.
Value investors believe that any mispricing of stocks will be immediately exploited by the market to arrive at net asset value.
Momentum investors have multiple explanations for why stocks may move in the direction they do.
Some of the hypotheses that explain it are behavioral finance, boundaries to arbitration thesis, and the rational attention thesis.
While these may sound like Greek and Latin, they are actually very easy to understand.
Behavioral finance takes into account the psychology of investors in the market. It helps to understand the biases that cause investors to under- or over-react to information.
The limits for arbitrage theory say that restrictions on capital or legal limits can prevent investors from making the most of an opportunity.
The rational attention thesis states that some information can be evaluated less carefully, or even outright ignored. This can lead to investors investing too much or too little and can cause a trend to continue.
Is it a new strategy?
Surprisingly, momentum investing is one of the oldest investment strategies in the world. It existed long before Benjamin Graham introduced value investing to the world in 1934.
In fact, momentum investing can be traced back as far as the 1800s.
In the book, The Great Metroplis, Part 2, author James Grant wrote of David Ricardo. He was an English economist who made a large fortune in the late 1700s and early 1800s by trading both bonds and stocks.
Following in Ricardo’s footsteps were some Wall Street legends who implemented these techniques.
These were Charles H. Dow, the co-founder of Dow Jones and Company, Nicholas Darvas, the economist who invented the “BOX theory,” and Jack Dreyfus, who Barron’s named the second most important money manager of the last century.
Types of Momentum Investing
Momentum investing can be broadly classified into two categories: relative momentum investing and absolute momentum investing.
1. Relative Momentum Investing
Here, investors compare the relative performance of securities and buy better-performing securities and avoid or under-sell.
They then rebalance their portfolio at intervals and alternate between a subset of securities.
Relative momentum is also known as: cross-sectional momentum investing.
2. Absolute Momentum Investing
In this, investors compare a security with its own historical performance. They buy securities that have yielded positive returns and sell securities that have yielded negative returns.
Absolute momentum is also referred to as time series follow momentum or trend.
The difference between the two is that relative momentum does not take into account whether returns are negative or positive. If all securities lose value, investors will still invest in assets that decline the least.
On the other hand, in absolute momentum, the direction of returns plays an important role. Investors will avoid stocks that have returned negative returns and only invest in stocks that have provided positive returns.
Does Momentum Investing Really Work?
It does!
There is a lot of evidence, both academic and otherwise, that momentum investing works.
A research paper by Asness, Liew and Stevens (1997) shows that momentum investing is a profitable strategy for country indices.
Another finds that a simple momentum model creates unusually large gains on foreign exchange transactions.
Recent studies, such as those by Luu and Yu (2012), say that the strategy also works for liquid fixed income assets, such as government bonds, because it offers a good risk-return tradeoff.
History also shows that momentum investing has worked in about eight years out of ten.
In fact, on a risk-adjusted basis, the strategy supersedes many other investment techniques and the record seems to hold up over time, geography, asset class and different implementation methods.
Sounds tried, right? What’s the problem?
There are some risks.
One has to monitor the market daily and determine the time of entry and exit.
The key to momentum investing is being able to take advantage of volatile market trends. So one must be able to tolerate the volatility that comes with it.
Moreover, like any other strategy, momentum can cease to work if not applied with discipline.
One must also consider transaction costs of constantly buying and selling. As an individual investor, this can most likely lead to overall portfolio losses if not applied with caution.
To conclude…
To a value investor, momentum investing may seem completely crazy.
But we live in uncertain times and with markets at the peak of volatility, it would only make sense to use it to your advantage rather than let it beat you at your own game.
Momentum investing is not for the faint of heart, however. It also requires more skill and effort than value investing.
If you’re planning to dip your toes into the momentum investing world, make sure you do your homework and be fully equipped to deal with the pitfalls.
Disclaimer: This article is for informational purposes only. It is not a stock recommendation and should not be treated as such.
This article is from Equitymaster.com
(This story was not edited by DailyExpertNews staff and was generated automatically from a syndicated feed.)
