TAKING STOCK | Momentum Investing
Volatility Recorded
Over The Last 3 Decades
65
55
1500
45
1000
35
25
500
15
0
Jan-90
Jan-92
Jan-94
Jan-96
Jan-98
Jan-00
Jan-02
S&P 500 levels
and other very short-term momentum
techniques tend to underperform the
overall market by a wide margin especially
in less liquid assets where trading costs
may be much higher than the profits
that can be expected from a short-term
momentum investment. Generally, the
best time-frame to profit from momentum
effects are investments that are based on
the performance of an asset during the
last six to twelve months and held for one
to three months.
Another risk of momentum investing
are so-called momentum crashes. Trend
The flexibility of momentum strategies can
lead to excessive trading costs if momentum
signals are designed to switch quickly from
one asset to another
performance. Thus, in times like these,
a momentum investors takes refuge in
the fact that they can willfully switch
asset classes, stocks, commodities,
currencies, bonds, REITs or anything else
that has been hogging the limelight
over the last few months. In the current
scenario, that could mean him investing
in gold and expecting it to continue its
outperformance in the coming months.
Momentum investing, however,
does not come for free. The flexibility
of momentum strategies can lead to
excessive trading costs if momentum
signals are designed to switch quickly
from one asset to another. Day trading
April 2016 | www.wealth-monitor.com
75
CBOE VOLATILITY INDEX
2000
85
following investment strategies tend to
work most of the time – until they don’t.
Financial markets sometimes change
direction very quickly. Take for instance
the crash in October 1987 when US stock
markets fell by more than 20% in one
day without any real warnings. Similarly,
stock markets started to recover very
quickly at the end of the financial crisis in
March 2009. Most traditional momentum
strategies lost all their outperformance
from the previous ten years in the two
months from March to May 2009 because
the defensive stocks that had held up
reasonably well during the financial crisis
suddenly were outshined by the bank
Jan-04
Jan-06
Jan-08
Jan-10
Jan-12
Jan-14
5
Jan-16
Source: Investing.com
2500
S&P 500 LEVELS
strategy by investors and traders aiming
to capitalize on the continuance of an
existing trend in the price of an asset, with
the underlining belief that ‘Winners will be
Winners and Losers will remain Losers’. A
momentum investor will generally take a
long position in an asset that has shown
an upwards trend in the past or short sell
a security that has been in a downtrend
hoping to ride the trend.
Acknowledging that the financial
market in itself is a complex web making it
difficult to pick winners, sectors or stocks
(goes beyond just equities), momentum
investing advocates an investor would
rather do well adhering to a system which
could identify market leaders or laggards.
Ideally, it is essential to reliably identify the
same based on performance over the last
6-12 months. Stocks that have gone up the
most are said to have positive momentum
and are believed to outperform in the near
future while those with the worst returns
have negative momentum and would be
expected to continue their slip.
As economic cycles shorten and
volatility increases, it becomes imperative
to analyze this method of investing in the
‘new normal’. Commentators advocating
this way of investing underline it as being
one of the most flexible and dynamic
investing strategies – for this class of an
investor, asset type does not take center
stage; instead, what one focuses on is
CBOE Volatility Index
stocks and real estate stocks that started a
strong rally.
Recent research by Prof. Didier
Sornette from the Swiss Federal Institute
of Technology, however, might provide
some remedy against these momentum
crashes. His research indicates that
momentum investors are better off
combining momentum with acceleration.
Acceleration measures the change in
momentum over two subsequent time
periods. An investment has positive
acceleration if momentum is stronger in
the second period than in the first and
negative acceleration if momentum is
weaker in the second period than in the
first. Investors want to look for assets that
show positive momentum and positive
acceleration, i.e. situation where the price
is moving higher and the returns get
bigger and bigger over time. At the same
time investors want to avoid assets with
negative acceleration where momentum is
getting weaker over time. It is these assets
that seem most vulnerable to crashes.
So Newton’s first law of motion holds
true for financial markets as well, but
investors should be aware that, just like
in physics, there is always a chance that
the impact of other forces may lead to
a change in direction. Investors who are
trying to exploit momentum effects have
to be on the lookout for techniques that
mitigate the negative effects of sudden
changes in direction. With the techniques
explained here this might just be possible.
*Joachim Klement is a trustee of the CFA Institute
Research Foundation
41