Momentum is a word that leadership gurus and self-help experts throw around a lot. In those contexts, it means something like “the energy gained by moving.” The term itself has been applied to a strategy that first came to the fore in the mid-1990s and which gained interest in the early part of the twenty-first century. As you might guess, momentum investing has the world “momentum” in its name for a reason, though in this context, momentum means something more like “fair weather” than it does “energy.”
Because of what’s happened in recent times, some have asked “Is momentum investing dead?” The answer would depend on where we are in a market cycle — after all, fads come and go, only to return again. Let’s take a closer look at what momentum investing is.
What Is Momentum Investing?
Momentum investing is sometimes called “fair weather investing”, which capitalizes on what’s called the “bandwagon” effect. The technique is relatively straightforward: buy stocks and other financial instruments that have performed well over the last quarter or last year (that is, three to twelve months). At the same time that you’re buying well-performing stocks, you’re also selling under-performing ones. The goal is to focus on stocks that are gaining momentum, while the expectation is that the push continues for 6 months to a year beyond the initial movement. The strategy is not about long-term growth but about making profitable returns; in a nutshell, it’s about chasing investment performance.
Many well meaning investment gurus will tell us that chasing performance and returns is pure folly, but it’s tempting to do, since it falls very much in line with our natural behavior and instincts as profit-seeking individuals. The key is to either learn how the professionals do it, or let the professionals do it for you. There’s also an element of investment timing in this approach, which yields an average return of about 1% every month for the three to twelve month period following the initial trade. Thus, there is a specific short time horizon within which this approach may be optimal.
Mutual Funds & ETFs Geared Towards Momentum Investing
Like with traditional forms of investing, momentum investors can turn to investment managers for assistance. There are even mutual funds and stock-slates devoted to this pursuit. Let’s consider these returns on popular momentum funds:
This table doesn’t give us a lot of answers on its own, unfortunately. But the story behind the numbers may say something. Momentum investments did moderately well in the early to mid-1990s. They tended to follow traditional benchmarks and was seen, in many ways, to be a form of “eccentric” investing — something that quirky investors did. Then with the Internet craze in the late 1990s, momentum investors began to make huge returns, outpacing traditional benchmarks in many cases. Alas, this huge growth couldn’t be sustained. Funds like American Century Ultra, Turner Midcap Growth, and Brandywine all suffered when the Internet pop happened in late 1999 / early 2000s. This all but guaranteed that those funds would perform poorly for many annual cycles to follow, which you can see in their average 10-year returns.
By contrast, take a look at the last three funds in the chart. Cliff Asness, a huge believer in momentum investing and principal at AQR CORPORATION, launched all of the AQR indexes and mutual funds in July 2009. As you can see, these are pretty new funds which have performed amazingly well, with average returns of well above the 4%-5% benchmark set by traditional investment strategies (thus far). They don’t have much of a track record yet, so it’ll be interesting to see how things play out.
So what makes momentum investing work? The rationale is that stocks that have performed well over the last 12 months, excluding the most recent month, will continue to outperform for at least 3 to 12 more months. Momentum works when investors stick to their guns, even if they don’t understand the reasons why a stock or fund is gaining steam.
I often use Apple products as my example, because so many of us use Apple products and can understand the craze that has led Apple’s stock price to skyrocket. So let’s turn to this example again. Remember when the iPhone was first introduced? It was cool, but we assumed that anyone who had one was just carrying around a bigger version of the iPod. The craze over the iPhone wasn’t instant but it eventually took off, sparking the rise in Apple’s stock price. Momentum investors would have picked up on this much earlier than most of us who jumped on the bandwagon later. They would have watched the release of the iPhone very carefully and would have begun buying the stock as soon as its returns over the past 3 to 12 months showed an increase.
Here are other potential instruments in the trend following field. These are exchange traded funds or notes (ETF or ETN). Note that these are very new vehicles and won’t have much of a long term record for analysis.
Well Known Momentum Investors & Traders
Let’s take a look at a few well-known momentum investors, starting with George Soros, who may be the earliest investor to use momentum strategies. Soros used aggressive tactics to build his astounding wealth, and persists, to this day as one of the biggest and most influential names in the investment world. His name is tied to aggressive investment practices as opposed to other stalwarts like value player Warren Buffett and index guru John Bogle.
Richard Driehaus, however, was the first person to actually use momentum investing on a wide-scale. Driehaus is a money manager from Chicago who does not believe in the traditional mantra of “buy low, sell high.” For him, the strategy boils down to buying what’s hot and selling what’s hotter.
Commodity trader and speculator Richard Dennis is known to have started the trend following strategy called “turtle trading”, which is implemented against futures and commodities. The popular mantra of “the trend is your friend” is embraced by many such traders who follow a momentum philosophy.
Where To Learn More About Momentum Investing
If you’re compelled to try out momentum investing (or trading) despite all the caveats, then I suggest that you do ample research before jumping in. There are a number of resources that can help you determine if this form of investing is really for you.
Beginners’ books such as the general how-to investing tome called Investing For Dummies outlines the momentum technique in easy to understand language. Intermediate investors can look into How to Make Money in Stocks: A Winning System in Good Times or Bad by William J. O’Neil. This excellent book explores a first-hand account of this kind of investing. Another book you may want to check out is Smarter Investing in Any Economy: The Definitive Guide to Relative Strength Investing. Remember, an informed investor is a confident investor.
Should You Follow The Herd?
On The Digerati Life, we strongly advocate investment diversification, and we prefer to recommend more conventional ways to invest. But for those who insist on following the herd and chasing stock or market trends, we’d recommend that you opt for a momentum fund or ETF rather than pursue a “high-flyer” on your own. Momentum portfolios are based on the premise that there’s always a bull market or a trend to exploit, somewhere.
You may wonder whether momentum strategies can be combined with more traditional investment and trading methods. There are die-hard investors who would say “absolutely not”, claiming that it defeats the purpose of momentum investing to dilute your portfolio with traditional assets. I, however, disagree. I’m not that big of a risk-taker and I prefer to have as much control of my portfolio as I can. I believe that a more comprehensive approach is to diversify your portfolio among solid (perhaps even index) ETFs, and to use a mutual fund or two in the momentum as well as value investing arenas.
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