How momentum investing works, what are some of the challenges in implementing it, and how can individuals use momentum in their investment portfolios.
In this episode you’ll learn:
- What is momentum investing and why does it theoretically deliver excess return.
- Why do momentum strategies suffer through periods of horrendous losses.
- Why high trading costs and selling a position can be challenges to successfully implementing momentum strategies.
- What are examples of momentum oriented funds and ETFs.
- How momentum can be used for making asset allocation decisions and adjusting portfolio risk.
Not all investment strategies take intrinsic value into consideration—in fact, momentum investing is based entirely upon current performance. If a security has consistently performed well, then it is considered a winner. “Trend following” is another term for the strategy of investing in what is currently working extremely well. The turnover can be relatively high, but the key characteristic of momentum investing is that it works.
What drives the success of momentum investing?
Momentum investing has been utilized for hundreds of years and focuses on what is performing at its best at the moment. The investment can belong to any asset class, and it has historically outperformed the market. Momentum makes a good complement to the value style of investing because when value performs well, momentum is often underperforming—and vice versa. Those who utilize both value and momentum investing strategies in their portfolios tend to be rewarded with both balance and profitability. Why does the momentum factor perform so well? There are a couple of basic views on why momentum investing works—all of which have to do with the behavioral influence of investors.
- The first view is that investors who don’t pay attention to an underperforming company stock or bond tend to leap on the bandwagon all at once when the company begins to flourish. Inattention to the intrinsic value and underreaction to the initial growth of the speculation can cause a massive 180 degree turn when things begin to go well.
- The second view is the exact opposite. Overreaction and aggressive trading in a company stock leads to investment herding, driving the price of the stock higher than it is actually worth.
The three setbacks that make momentum investing risky
While there are many positives to momentum investing, there are drawbacks. David lists three challenges surrounding the strategy.
- A push by momentum oriented investors into a less liquid stock can lead to higher trading costs in terms of the market impact. With momentum investment, the holding turnover rate is also high, driving trading costs up as well.
- A careless sell discipline can lead to tragedy in momentum strategy. The volatility of momentum investments means that they can crash as easily as they can rise. If you don’t vacate the stock quickly enough, the cost could be great.
- New momentum is better than stale momentum. You want to find stocks that are young in their fast growth rate—not dormant and unmoving.
Momentum investing is influenced by the behavior of the investors utilizing the strategy. Because of the natural course of human nature, it is unlikely that there will be any major change in the way momentum strategy develops.
Two ways to utilize dual momentum to move in and out of asset classes.
There are two types of momentum. One is relative momentum, which compares the price performance of one asset to another. Whichever asset outperforms the other is the winner. The second type is absolute momentum, which compares the current performance of the asset to its historical performance. When an investor finds an asset that demonstrates both positive relative and absolute momentum, they overweight that asset in their portfolio a strategy known as “dual momentum.” There are a couple of different ways to operate under the dual momentum strategy, but a popular one is called the Global Equities Momentum (GEM). In this strategy, the first step is to see if the S&P 500 outperformed U.S. T bills over the last 12 months. If not, then you would invest in the Bloomberg Barclays U.S. Aggregate Bond Index or an ETF. If yes, then you would compare it to the MSCI World Ex-U.S. Equity Index. Whichever outperforms is the one you invest in. David does advise listeners to consider the historical consistency of those indexes, as there can be a wide range of volatility in their historical performance.
The different roles that momentum investing can play in your portfolio
One of the easiest ways to step into momentum investing is through Exchange-Traded Funds (ETFs) that utilize momentum. Because of the high trading funds, the lack of sell-discipline, and the risk of suffering a crash, the investing strategy isn’t for the faint of heart. It can go through periods of incredible outperformance of the market and seasons of devastating underperformance.
One tactic that David discusses is using momentum investing strategy as a swing vote. When considering an investment that appears attractively priced, note of whether the trend is positive or negative. Don’t purchase an asset category just because it is cheap. Be patient and wait until you believe the asset has hit rock bottom and then beings to rebound. Invest as you see the infant stages of regrowth. While momentum investing has its risks, it isn’t something that should be ignored. Use it as a signal in trend following or as a swing vote in your investments to create a stronger portfolio.
- [0:18] Momentum investing consistently outperforms the market.
- [5:04] Why does momentum investing work?
- [7:31] The three challenges of the momentum investing phenomena.
- [12:50] What happens if investor behavior changes?
- [14:24] Tactics for implementing momentum into your own portfolio.
- [20:02] Using dual momentum to move in and out of asset classes.
- [23:55] Utilizing momentum investing as a swing vote.
- [28:01] How David uses momentum investing in his portfolio.
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