In the vast ocean of investment strategies, momentum investing stands out as a surfboard that catches the biggest waves. Unlike its more intuitive cousins such as value or quality investing, momentum doesn’t rely on fundamental analysis of a company’s financials. Instead, it’s all about riding the wave of market sentiment.
What is Momentum Investing?
At its core, momentum investing is based on a simple premise: what goes up, will keep going up (at least for a while). This strategy involves buying stocks that have performed well in the recent past and selling those that have performed poorly.
There are two main types of momentum strategies:
- Time Series Momentum: This is like watching a single wave grow. It involves comparing an asset’s current price to its own historical prices. For example, a trader might buy when a stock’s price rises above its 200-day moving average.
- Cross-Sectional Momentum: This is more like choosing the biggest wave on the beach. It involves comparing different assets to each other and selecting those with the strongest relative performance over a specific period, typically 3-12 months.
In this article, we’ll focus primarily on cross-sectional momentum, which is more commonly used in stock selection strategies.
The Academic Surf Report
Momentum investing isn’t just a gut feeling or a trader’s superstition. It has solid academic backing. The concept first gained widespread attention in the academic world in 1993, when researchers Narasimhan Jegadeesh and Sheridan Titman published their groundbreaking paper, “Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency”.
Their research showed that investors could generate excess returns by buying stocks that had performed well over the past 3-12 months. This finding sent shockwaves through the academic community, challenging the efficient market hypothesis and opening up new avenues for research in behavioral finance.
Subsequent studies have refined this approach, and many academics now use a measure called “twelve minus one” momentum. This looks at a stock’s performance over the past year but excludes the most recent month. Why? Because very short-term price movements tend to reverse, and excluding the most recent month actually strengthens the momentum signal.
In the following sections, we’ll dive deeper into why momentum works, how it can be enhanced, and what pitfalls to watch out for when surfing these market waves.
Why Does Momentum Work?
Imagine you’re at the beach, watching waves form and crash. Some waves start small but gather strength, becoming towering behemoths by the time they reach the shore. Momentum in the stock market works in a similar way, and there are a few theories as to why:
The Behavioral Tsunami
The most widely accepted explanation for momentum’s success is rooted in behavioral finance. Just as a small disturbance in the ocean can grow into a massive wave, small changes in a company’s fortunes can snowball into significant price movements.
Here’s how it works:
- Good news about a company emerges.
- Investors, being human, often underreact to this news initially.
- As the positive information slowly sinks in, more investors buy the stock, pushing the price up further.
- This cycle continues, creating a self-reinforcing trend.
This underreaction followed by a gradual acceptance of new information creates the momentum effect that investors can capitalize on.
The Reflexivity Rip Curl
Another explanation, popularized by George Soros, is the concept of reflexivity. In surfing terms, think of it as a rip curl that feeds on itself:
- A company’s stock price starts rising.
- The rising stock price itself becomes a positive factor for the company.
- It becomes easier for the company to raise capital, attract talent, and make strategic moves.
- These improvements in the company’s position lead to further stock price increases.
A prime example of this was Tesla during its meteoric rise. The company’s high stock price allowed it to raise capital easily and attract top talent, which in turn fueled further growth and stock price appreciation.
The Risk-Reward Reef
Some argue that momentum stocks outperform simply because they’re riskier. Just as the biggest waves offer the best rides but also the hardest wipeouts, momentum stocks might offer higher returns as compensation for higher risk.
However, most academics view this explanation skeptically. The behavioral explanations are generally considered more plausible.
Surfing Techniques: Enhancing Momentum Strategies
While riding the momentum wave can be profitable on its own, skilled surfers know that technique matters. Similarly, researchers have found ways to enhance momentum strategies:
The Smooth Ride Advantage
Research by Wes Gray and Jack Vogel, detailed in their book “Quantitative Momentum,” found that consistent momentum often leads to better results. If two stocks have the same overall return, the one that took a smoother path to get there is often a better bet than one that experienced wild fluctuations.
The Fundamental-Price Pipeline
Just as surfers look for the confluence of wind, swell, and seafloor topography to find the perfect wave, some investors combine price momentum with fundamental momentum. This approach, explored by Dashan Huang and his colleagues and the basis for Validea’s Twin Momentum strategy, looks for stocks where both the price and the underlying business fundamentals are improving.
This combo approach can offer two benefits:
- Potentially higher returns
- A fundamental rationale that may help investors stick with the strategy during rough patches
The Factor Fusion
Momentum also plays well with other investment factors, particularly value. Like mixing different surf breaks, combining momentum with value can offer a smoother ride. The excess returns of momentum and value tend to be negatively correlated, allowing investors to potentially achieve similar returns with less overall risk.
In the next section, we’ll look at some of the challenges and downsides of momentum investing – because even the best surfers need to be aware of the dangers in the water.
Wipeouts and Undertows: The Downsides of Momentum
Even the most skilled surfers face risks, and momentum investing is no exception. Let’s explore some of the challenges:
The Constant Paddling Problem
Momentum strategies typically require more frequent trading than other approaches. Just as a surfer needs to constantly paddle to catch the best waves, a momentum investor must regularly rebalance their portfolio to maintain exposure to high-momentum stocks.
This frequent trading can lead to:
- Higher transaction costs, which can eat into returns
- Potential tax inefficiencies in taxable accounts, as short-term gains are realized more often
The Changing Tide Challenge
Momentum strategies can struggle during major market shifts. Imagine a surfer perfectly positioned for a wave, only to have the tide suddenly change direction. Similarly, when market leadership changes abruptly, momentum portfolios may be caught holding yesterday’s winners.
For instance, 2009 was a challenging year for momentum strategies. As the market rebounded from the financial crisis, many stocks that had performed poorly suddenly surged. Momentum portfolios, still holding the previous regime’s winners, took time to adapt to this new reality.
Conclusion: Respect the Wave
Momentum investing, like surfing, can be exhilarating and rewarding when done right. It offers a unique approach to capturing market trends and has a strong academic pedigree to back up its effectiveness.
However, it’s crucial to understand both its strengths and limitations:
- Momentum has historically delivered strong returns, comparable to other major factors like value.
- It can be enhanced through techniques like focusing on consistent momentum or combining with fundamental analysis.
- It works well in combination with other factors, particularly value.
- However, it requires more frequent trading and can struggle during abrupt market shifts.
Despite these challenges, momentum remains a powerful tool in the investor’s arsenal. It’s a factor that often doesn’t get the respect it deserves, perhaps because it lacks the intuitive appeal of strategies like value investing.
For investors willing to put in the work to understand and implement it properly, momentum can be like catching the perfect wave – a thrilling ride that can take your portfolio to new heights. As with surfing, success in momentum investing comes from respect for the power of the waves, understanding the conditions, and continuous practice and refinement of technique.
So grab your board, study the tides, and get ready to ride the momentum wave. Just remember, even the best surfers know when to paddle back to shore and wait for the next set.
Further Research
