The great investment strategies: momentum investing

Momentum investing is as much about understanding human nature as measuring the market value of financial assets. Julian Hofmann explains how to make this 300-year-old strategy work for you.

Momentum investing has always been something of a curiosity within the gallery of established investment strategies. At its core, it seeks to take advantage of a simple premise in the markets: investors will always overreact to either good or bad news, so momentum seeks to take advantage of the resulting arbitrage – in other words, the mispricing of risk based on the failure of people to adjust their personal expectations in-line with reality. Indeed, some commentators say that understanding human psychology is the last edge that canny investors have in the modern market.

Price is of no consequence

Unlike value or growth investing, price itself is little consequence when it comes to momentum strategies - momentum investors will happily pay premiums for rising shares, making a judgement that investors are prepared to do the same over a six-to-12-month period.

This time frame is a natural way to find market alpha (performance against a benchmark) from individual shares that would otherwise only perform in line with the rest of the index. The key to success lies in understanding that investors will project current news whether it is good, or bad for longer into the future than is justified; herd behaviour and return-chasing are as great a part of the investor experience as soberly judged analysis.

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In summary, momentum is the closest that investors will get to grappling with the complexities of behavioural finance and, while we may think of it as a modern phenomenon, it has a surprisingly long history.

The origins of momentum

We can find the first description of “momentum” as far back 17th century Holland during the glory of the Dutch golden age. While we associate that period with painters like Rembrandt, Vermeer and Van Hals, financial innovation pioneered at the time allowed Holland to finance the acquisition of a large overseas empire. These innovations were then imported into the City of London after William of Orange came over and ousted the Stuart dynasty.

Joseph de la Vega (1650-1692) was an Amsterdam resident of Spanish Sephardic Jewish heritage. His family, like many Spanish Jews fleeing the Inquisition, had found refuge in Amsterdam’s climate of political and religious tolerance. A diamond trader and financial speculator, de la Vega published one of the earliest treatise on the financial markets in existence, based on his experience with the fledging and innovative Amsterdam Stock Exchange.

Published in Spanish as Confusion de Confusiones (Confusion of Confusions), it was originally intended to be an entertaining guide to the Amsterdam exchange for the educated Spanish community in the city. While it can’t be considered a manual for investing on its own, it still describes many of the same complex financial instruments and investor behaviours - derivatives, arbitrage, swaps, shorting, herding (another term for momentum), over-confidence, regret-aversion – that we understand today.

It also helps that de la Vega had a gift for a pithy sentence. In his rules for investing, he states: “He who wishes to become rich from this game must have both money and patience.”

How very true.

The downsides

The problems with momentum strategies are focused on how long the shares are held. It tends to work for a few months at a time before a portfolio must be rotated in advance of the momentum effect going into reverse. This can raise trading costs significantly and might mean sacrificing the dividend returns that income investors prize.  

For its many advantages as a trading strategy, it is hard to understate how disastrous a momentum reversal can be in the context of a falling market.

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Take the spring and summer of 2009 as an example. The stock market crash in the autumn of 2008 was led mainly by financial stocks that had over-reached themselves during the credit boom of the early 2000s. As banks and other financial institutions were deeply unpopular at the time, momentum investors naturally rotated out of the sector. Unfortunately, the rising market, led by the same financial stocks, caught momentum investors on the hop, and returns for the strategy were meagre when compared with those for investors who followed value strategies in a rapidly rising market. Defenders of momentum point out that the last time this reversal happened was in 1932 and that the strategy has otherwise remained remarkably consistent.

Is volatility helpful?

It is also important to remember that you are dealing with peoples’ cognitive bias. Perceptions of volatility are a case in point. Economists at the University of Georgia discovered an interesting scenario where volatility can help the process of momentum. For instance, a small company will naturally have a more volatile share price than a large blue-chip firm. So, when it announces good news, it is often dismissed as part of the overall chatter around a stock, which causes the share price to underreact initially, but then to drift upwards as the news is eventually digested as positive.

A low volatility blue-chip, by contrast, needs news of a greater order of magnitude for investors to take notice – a big acquisition, for instance. The paradox is that, while this can generate momentum in the short term, it reverses rapidly as the share price performance reverts quickly towards the mean. Arguably, therefore, a measure of selectivity is needed to take full advantage of the momentum effect.   

The efficient market hypothesis

The existence of momentum is, in many ways, a slap in the face to the idea that financial markets are inherently efficient at pricing risk. The dominant thesis over the past 40 years, or so, at least until the 2008 financial crash, was that the price of financial instruments is determined by all the available information in the market, and that investors will trade rationally on the back of that information. In other words, it is all in the price – to quote the lazier sort of stock market commentator.

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While the financial crash exposed the flawed assumptions behind the theory, the biggest problem is that it just does not take account of peoples’ collective behaviour. John Maynard Keynes is rightly celebrated as one of the greatest economists that Britain has ever produced, but he was also a pretty mean stock market operator – making, and losing, several fortunes along the way.

Keynes’ great insight as an investor was that the market is driven by “animal spirits” - the collective decisions of thousands of individuals - that together are more powerful than any single intervention. I think it is hard to come up with a better definition of momentum than that. You can read our in-depth analysis of Keynes’ contribution to investment theory and practice as part of this series.