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 of generating wealth in the last few decades.
Its what legendary investors such as Warren Buffett and Charlie Munger swear by. It’s what has made them some of the richest men in the world.
However, the investing style has fallen out of favour with investors since 2007. Its poor performance was amplified after the March 2020 crash.
The liquidity injected by central banks all over the world added a boost to 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 must be equipped to handle the new normal.
So how should one go about it? Is there another strategy one can use?
Of the many investing strategies available, one comes to mind.
What is momentum investing?
Momentum investing is a strategy in which investors buy outperforming securities and avoid or sell underperforming ones.
It’s built on the premise that stocks that have gone up will continue to go up or vice versa.
The goal is to work with the ‘momentum’ by finding buying opportunities in an up trend and then sell them when they start to lose steam.
Value investors believe any mispricing in stocks will be immediately exploited by the market to arrive at the intrinsic value.
Momentum investors have multiple explanations for why stocks may move in the direction they do.
Some of the hypotheses that explain it are behavioural finance, limits to arbitrage thesis, and the rational attention thesis.
While these may sound like Greek and Latin, they are actually very simple to understand.
Behavioural finance takes into account the psychology of investors in the market. It helps to understand the biases that cause investors to either under or overreact to information.
The limits to arbitrage theory says that restrictions on capital or regulatory limits could prevent investors from making the most of an opportunity.
The rational attention thesis states that some information may be evaluated less carefully, or even outright ignored. This can cause investors to over or under invest and could cause a trend to persist.
Is it a new strategy?
Surprisingly, momentum investing is one of the oldest investing strategies in the world. It was in existence much before Benjamin Graham introduced value investing to the world in 1934.
In fact, momentum investing can be traced back to as early as the 1800s.
In the book, The Great Metroplis, Volume 2, author James Grant wrote about David Ricardo. He was an English economist who amassed a large fortune trading both bonds and stocks in the late 1700s and early 1800s.
Following Ricardo’s footsteps were some of Wall Street’s legends who implemented these techniques.
These were Charles H. Dow, the co-founder of Dow Jones and Company, Nicholas Darvas the economist who invented ‘BOX theory’, and Jack Dreyfus, who Barron’s named the second most significant money manager of the last century.
Types of momentum investing
Momentum investing can broadly be classified into two categories – relative momentum investing and absolute momentum investing.
1. Relative momentum investing
In this, investors compare the relative performance of securities and buy outperforming ones and avoid or short-sell underperforming ones.
They then rebalance their portfolio at intervals and rotate 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 against its own historical performance. They buy securities that have delivered positive returns and sell securities that have delivered negative returns.
Absolute momentum is also referred to as time-series momentum or trend following.
The difference between the two is that in relative momentum, one does not take into account whether the returns are negative or positive. If all securities are losing value, investors will still invest in assets that are falling the least.
On the other hand, in absolute momentum, the direction of returns play an important role. Investors will avoid stocks that have delivered negative returns and only invest in those that have delivered positive returns.
Does momentum investing really work?
It does!
There is a lot of evidence, academic and otherwise, proving 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 profits in foreign currency trades.
Recent studies such as the one by Luu and Yu (2012), says the strategy works for liquid fixed-income assets as well, such as government bonds, as it provides a good risk-return trade-off.
History also shows that momentum investing has worked in about eight years out of ten.
Infact, on a risk-adjusted basis, the strategy comes out ahead of many other investment techniques and the record appears to hold up over time, geography, asset class and various implementation methods.
Sounds tried and tested, right? So what’s the problem?
There are some risks.
One has to monitor the market daily and time one’s entry and exit.
The key to momentum investing is being able to capitalise on volatile market trends. Thus, one has to be able to stomach the volatility that comes with it.
Moreover, like any other strategy, momentum may cease to work if not applied with discipline.
One must also take into account transaction costs of the constant buying and selling. As an individual investor, this may most likely lead to overall portfolio losses if not practiced with caution.
To conclude…
To a value investor, momentum investing may seem totally 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 than to let it beat you at your own game.
However, momentum investing is not for the faint hearted. It also requires more skill and effort than value investing.
If you do plan to dip your toes in the world of momentum investing, be sure to do your homework and be entirely equipped to deal with the pitfalls.
Disclaimer: This article is for information purposes only. It is not a stock recommendation and should not be treated as such.
This article is syndicated from Equitymaster.com
(This story has not been edited by NDTV staff and is auto-generated from a syndicated feed.)
