What is Momentum Investing?
Momentum investing is an investment strategy that aims to capitalize on the continuance of existing trends in the market. To participate in momentum investing, an investor takes a long position in an asset that has shown an upward trending price, or the investor short-sells a security that has been in a downtrend. The basic idea is that once a trend is established, it is more likely to continue in that direction than to move against the trend.
Momentum has been extensively studied and studies show that stocks with the best price performance over the previous 6-12 month period tend to continue to outperform the market over the subsequent 6-12 month period while previous losers tend to continue underperforming. Typically, stocks are ranked by momentum and the top 10 percent are selected for long positions and the bottom 10 percent are selected for short positions.
While other trading strategies stop being profitable once they have been discovered (because investors start exploiting them, removing the profit opportunity), momentum has remained surprisingly lucrative ever since Jegadeesh and Titman (1993) first documented it. To quote Asness, Frazzini, Israel and Moskowitz, "Fact, Fiction and Momentum Investing," 2014, who have studied the momentum factor extensively:
“No other factor, save perhaps the market itself (and that is far from clear), has nearly as long a track record (remember there is evidence of momentum for the past 212 years), as much out-of-sample evidence (including across time, geography and even security type), or as strong and reliable a return premium as momentum.”
Why Does It Work? It’s Based on Human Nature
Momentum’s success as a strategy is pervasive – it has been shown to outperform market benchmarks, not only in stocks, but also bonds, commodities and currencies as shown by Asness, Moskowitz, and Pedersen (2013). The fact that it has been shown to work on multiple asset classes and across geographies and timeframes reinforces the notion that its success is caused by persistent and universal human behaviors and biases.
Conventional market wisdom holds that markets are either efficient and/or random. If all buy and sell decisions were made by emotionless computers, then this would probably be the case. However, human beings trade in markets and humans are ruled by fear, greed, and ignorance. This causes trends in the market to be persistent. The “smart money” identifies an undervalued area of the market and moves in driving up prices. Eventually other investors start to see this and they buy as well, further moving prices up. Eventually fear kicks in and money moves out of the asset class into something else and the process starts all over again.
E. P. Chang, in his book, “Quantitative Trading” puts it this way:
“Momentum can be attributed to the herd-like behavior of investors: investors interpret the (possibly random and meaningless) buying or selling decisions of others as the sole justifications of their own trading decisions. As Yale economist Robert Schiller said in the New York Times (Schiller, 2008), nobody has all the information they need in order to make a fully informed financial decision. One has to rely on the judgment of others. More problematically, people make their financial decisions at different times, not meeting at a town hall and reaching a consensus once and for all. The first person who paid a high price for a house is “informing” the others that houses are a good investment, which leads another person to make the same decision, and so on. Thus, a possibly erroneous decision by the first buyer is propagated as “information” to a herd of the others.”
Lemmings: The key is to know when not to go over the cliff.
As cited in the Risk Model section of this website, in 2005, Kevin Lansing authored a study at the Federal Reserve Bank of San Francisco in which he created a behavior model to test his hypotheses about human behavior and stock market bubbles. His model showed that it doesn’t take very much human error to generate extrapolative expectations. If people start believing, even for a short time, that recent trends are the new normal, they will start paying higher prices, which locks the trend in place and lends credence to their belief. Eventually things spiral out of control before they come to their senses. According to Lansing, investors have rational incentives to economize on the costs of collecting and processing information. The conclusion:
Built-In, Automatic Risk-Management
Momentum strategies inherently contain risk-management characteristics that make them robust. They have natural stop losses (exit when momentum reverses) and no natural profit caps (keep same position as long as momentum persists): let winners run, cut losers short. Because of this, momentum strategies are very robust or as Nassim Taleb would say, anti-fragile.
In contrast, mean-reverting strategies, like value investing for instance, have natural profit caps (exit when the price has reverted to mean), but no natural stop losses (we should buy more of something if it gets cheaper), so it is very much subject to left tail risk, but cannot take advantage of the unexpected good fortune of the right tail. As such, mean-reverting strategies are fragile. The bottom line is that momentum strategies include inherent risk-management characteristics, which suit our “don’t loss money” philosophy.
Price Cannot Diverge From Itself
In “Being Right or Making Money”, Ned Davis (ndr.com) explained it better than almost anyone:
“Valuation does not guarantee of price, which is what we are trying to forecast. More often, valuation is a measure of risk level. Price, as many of us learned in economics 101, is determined by the laws of supply and demand, which are in turn bounded by the human emotion of fear and greed! What's unique about price momentum based ranking systems that no other variable can claim, is that price cannot diverge from itself. Valuation, earnings estimates, and economic fundamentals all have potential to move in the opposite direction of price, but price cannot diverge from itself. As a result, price momentum based ranking systems will lock on to the correct side of the trend. They also tend to get us out after a modest drawdown, thereby allowing profits to run, while losses are cut short.”
So Why Doesn’t Everyone Use Momentum? It is Misunderstood: Myths About Momentum Investing
Momentum investing was academically discovered only little less than 25 years ago. In spite of this, many misconceptions are held about momentum investing. Cliff Asness, etal. addressed some of these in the paper “Fact, Fiction and Momentum Investing.” Some of the myths about momentum refuted in the paper included the following:
Because these myths exist, many investors remain skeptical about momentum as an investment factor, which is why we can expect it to continue to persist as a basis for market out-performance.
The most important reason for the lack of acceptance of momentum strategies is that they experience a phenomenon called “momentum crashes.” Even though momentum strategies do well on average, there are some periods where they do very badly, an example of which is the 2008-2009 hedge fund crisis, when some hedge funds went under because they followed momentum strategies that tanked. Remember, traditional momentum strategies are designed to be "market neutral," long the top 10% in terms of momentum and short the bottom 10% in terms of momentum in equal parts. When markets decline precipitously, momentum strategies can "crash."
For example, between March and May 2009, the “losers” or short leg (bottom 10% in momentum ranking) of a typical momentum strategy gained 163%, while the “winners” or long portion (top 10% in momentum ranking) of the strategy generated only 8%. The losses on the short side of the strategy erased almost all the profits gained in previous years.
The reason is that the during a major market downturn the stocks ranked worst from momentum are typically deeply-discounted value stocks that have bottomed and lead the market's recovery. In contrast the stocks ranked best for momentum after a market collapse are dividend payers like utilities or low beta stocks like consumer staples whose upside in a recovery is more limited.
To summarize, momentum strategies make money on average, but in bear markets they can suffer extreme drawdowns and losses that give back a major portion of the returns gained during the previous bull market. Once the “losers” turn around, they punish the short leg of the momentum strategy.
In the academic paper (“Momentum Crashes”), Kent Daniel and Toby Moskowitz provide a solution to help avoid momentum crashes.
The answer Daniel and Moskowitz provide is surprisingly simple: get out of the momentum strategy in times of market stress, when the market has recently declined, and market volatility as measured by the VIX volatility index is high.
Where have you heard that before? It is what our Safeguard 1st Risk Model is all about! The Daniel and Moskowitz paper validates our risk management approach based on our Safeguard 1st Risk Model. The negative effects of momentum crashes on our momentum strategies are eliminated in three important ways:
Remember almost no professional investor is willing go completely to cash when times are dangerous, so we don’t believe we have to worry about widespread adoption of momentum strategies like ours undermining their potential for continued performance in the future.