Momentum Investing – The Trend Is Your Friend
The saying “buy low, sell high” is one almost every investor would have heard and no doubt one that many base each and every one of their investment decisions on – After all there is no point in buying a stock that’s just soared past its all-time high, surely there will be little if any upside left at that point. Surely investment “gravity” or mean reversion will pull these high-flying stocks back down to earth…Right?
Well as It turns out the exact opposite of this appears to be true, stocks that have done well in the past tend to perform well in the future and stocks that have not done well tend to continue to do so; even in the long run. Of course, there are exceptions to this rule but as it turns out this tendency for markets or individual assets to “trend” in a particular-direction (Which we refer to as the momentum effect) is actually-one of the most powerful all-pervasive phenomena’s in investment markets. To gauge the magnitude of this so-called momentum effect let’s take a look at a London Business School report that compared the relative performance of a portfolio of two UK equity portfolios since 1900. One composed of the best 20 performers on the stock market in the previous 12 months and one composed of the worst 20 performers over that same 12 month period. As it turns out the portfolio of the best performing stocks outperformed the worst performing stocks by 10.3% annually. Similar results have been found by countless other researchers in stock, bond, currency and commodity markets all over the world and over a number of different time periods.
Clearly then there is no shortage of evidence to point towards the fact that asset prices are subject to this momentum effect. With this in mind investors can begin to exploit this momentum effect with a momentum trading strategy which could potentially skew the return profile of their portfolio towards the right hand side I.E The investors positions their portfolio to maximise exposure to assets that are likely to experience abnormal gains. Rather simply this can be done by exposing your portfolio to stocks which have performed well in the past (And thus are likely to continue to perform well), particularly in the last 6-12 months which is where the momentum effect tends to be the strongest. Momentum strategies are particularly effective when both the individual stock and the broader market are undergoing a sustained move (Or re-pricing) to the up or downside as this sustained move is often the source of future momentum and thus can generate substantial returns for a portfolio.
However the momentum effect can also be used as a means to minimise risk on the downside as a momentum strategy can avoid stocks which have performed poorly (And are thus likely to continue to perform poorly) even if they may look attractive on backward looking valuation metrics like the stocks P/E ratio. Avoiding stocks which are likely to perform poorly is especially important when we consider the asymmetric nature of returns I.E a 10% loss requires an 11% gain to be back at break even. Arguably then a momentum strategies ability to avoid losers is even more important than its capacity to generate exaggerated performance.
At Harbourside Capital we put in place a momentum overlay on all of our investment strategies in order to exploit this anomaly at both a broad market and individual security level. Crucially this means that our portfolios are constructed in such a way that aims to maximises the chances of capturing gains on the upside but also minimises the possibility of capital loss.
Source – London Business School, The Economist
Harbourside Capital Pty Ltd (ACN: 166 765 537) is a Corporate Authorised Representative (CAR No. 448907) of HLK Group Pty Ltd (ACN: 161 284 500) which holds an Australian Financial Services Licence (AFSL no. 435746). Any information or advice contained in this article is general in nature and has been prepared without taking into account your objectives, financial situation or needs. All securities and financial products or instruments transactions involve risks. Past performance is not an indication of future performance.