Momentum Investing Strategy: Do You Have The Discipline

Momentum Investors try to keep all of their money invested in the current top performers all of the time. Great investments to a Momentum Investor are those that have outperformed the market and their peers during the last 12 months, with more emphasis on the most recent months. They don't worry about asset allocation or diversification because their strategy doesn't allow them to, the goal is to always be in the most popular and fastest growing investments.

Rather than using diversification and allocation to balance risk vs. return, they try to manage risk by moving quickly out of industries and assets that start showing signs of deteriorating performance. Momentum investors believe that the market is too complex to predict which industries or assets will perform well long-term. If they are right and what will become popular next is completely random, investors are better off developing a system that will identify the market leaders.

This is a research intensive and time sensitive strategy. Not only do Momentum Investors need a system that can reliably identify today's best investments, they must also have a system that warns them to get out of investments quickly when performance begins to deteriorate. Most of the research will be statistical analysis and technical analysis since these are the two types of analysis best suited to measuring short-term trends and short-term performance.

However, Momentum Investing is also one of the most flexible and dynamic investing strategies for those that master it. Momentum Investors will buy stocks, REITs, precious metals, currency, bonds, mutual funds, and anything else that is currently hot. Asset type doesn't matter, only performance. They will also temporarily invest as if they were following a different strategy when necessary. For example, if bonds are currently outperforming stocks, momentum investors will hop right on the Income Investor bandwagon, at least until momentum shifts elsewhere.

Investment Selection Methods

Momentum Investors use a combination of statistical and technical analysis to identify entry and exit points and which investments currently offer the best opportunity for rapid growth. Surprisingly, they don't try to predict when market cycles start or end. Momentum Investors are more concerned with identifying which industry or asset type is entering a mark-up phase (growth component of the market cycle) and getting their money in as quickly as possible.

The Standard Deviation, Beta, Alpha, and Sharpe Ratio are several of the common statistical measures that Momentum Investors use to analyze investments and the market. Statistical indicators can tell them a lot about recent performance and give them a way to benchmark investments against each other regardless of industry or asset type. Based on the long list of assets we mentioned in the Major Goals section, it's obviously important for Momentum Investors to be able to analyze assets that wouldn't ordinarily be compared against each other.

We won't spend a lot of time on statistics since your eyes just glazed over but we wanted to at least provide a basic intro to the most common metrics:

  • Standard deviation: Standard Deviation measures how much an investment deviates from its average. For example, if $5 is one standard deviation for a stock that averages $40 and it is currently trading at $55 this tells a Momentum Investor two important things. One, the stock is very volatile and two, it has a lot of positive momentum since it is currently trading three standard deviations above its average.
  • Beta: Beta is useful because it measures an investment's volatility against a benchmark. For example, if you are comparing Bonds to Small Caps and the Bond beta is 0.8 this tells us that Bonds will grow less than Small Caps, 20% less to be exact. If the Small Cap index goes up by 20%, this means the Bond index with a beta of 0.8 will only increase by 16%.
  • Alpha: Alpha compares an investment's expected performance, based on its beta, to its actual performance. If an investment has a negative alpha that means it underperformed expectations. Momentum Investors interpret this to mean that either the investment is poorly managed or that momentum is shifting somewhere else.
  • Sharpe Ratio: The Sharpe Ratio uses standard deviation to compare an investment's risk and returns. The higher the Sharpe Ratio the better an investment's returns have been relative to the risk it has taken on. The Sharpe Ratio is valuable because it is a relative measure, it allows Momentum Investors to accurately compare the risk and performance of completely different types of assets to each other.

Momentum Investors also incorporate technical analysis and charting. They focus on support and resistance levels and moving averages to try to identify investments that are entering a strong growth cycle, warn when a cycle appears to be ending, and to set buy limits and sell limits. Setting entry and exit points is important for Momentum Investors because the hottest stocks tend to fall much faster than the market when conditions turn bearish.

Since charting is not an exact science, most Momentum Investors also use simple weighted averages to measure the relative price strength of an investment. Weighted averages allow Momentum Investors to compare how well or poorly their investments are doing versus any other investment or market index. When the relative price strength weakens, Momentum Investors know that either momentum has shifted somewhere else or they are entering a bearish period.

Risks

This is not a strategy for timid or conservative investors, your portfolio will always be very volatile and will require constant attention. The analysis required for this strategy is relatively easy to master, but the need to monitor your portfolio and the market daily can wear on even the most diligent investors.

Perhaps the greatest risk of this portfolio is it lends itself to buying high and selling low. Momentum Investors are always trying to find the hottest investments, but if they aren't very good at statistical and technical analysis they'll frequently get in late (buying high). Or, they may have the reverse problem, they may not realize that momentum has shifted somewhere else and wind up holding too long (selling low).

Momentum Investors are willing to bounce between multiple assets such as REITs (Real Estate Investment Trusts), Bonds, Currencies, precious metals, funds, and Stocks to name a few. As a result, they can wind up in assets that they know very little about. When you are a novice trying to trade something as complex as currency, you can lose a lot of money fast.

While Momentum Investors argue that this isn't a danger, it's important to keep in mind that you will never have a balanced portfolio. The purpose of diversification and asset allocation is to optimize risk Vs return by having several asset types across many industries and geographies. Momentum Investing requires that you keep your money only in assets that are performing well right now so you have nothing to balance out losses. This makes risk management extremely important, Momentum Investors have to be good at getting out of bad investments quickly.

Benefits

Momentum Investors argue that their strategy is more effective than the traditional asset allocation and diversification approach because all of their money is optimized during bullish periods, none of their money is in lagging assets. For example, an Index Investor would always want some money allocated to Large Caps while a Momentum Investors would point out that sometimes even the best Large Caps underperform mediocre Small Caps and Growth Stocks.

Momentum Investing takes advantage of seasonality and constantly changing business cycles rather than suffering from them. For example, if a certain category of commodities shows strong price appreciation consistently every summer, a Momentum Investor's selection criteria would only suggest these commodities when they're doing well, never when they're lagging the market. The same holds true for business cycles, only investments that are in a growth phase will pop up on their radar.

Unlike many strategies that adhere to a specific mix, Momentum Investors can transition smoothly between investments held by any strategy. For example, it doesn't matter to a Momentum Investor if the market momentum shifts from value stocks to growth stocks, they can transition smoothly from one into the other because they are only concerned with performance.

Let's be honest, everyone wishes they had bought companies like Google, Microsoft, or Starbucks. Momentum Investors are constantly seeking the fastest growing and most popular investments. Like Growth Investing, Momentum Investing is one of the few strategies that give you the chance to hit a home run now and then.

Long-Term Outlook

Momentum Investing is not currently a popular stock market investing strategy but it certainly was attracting a lot of attention during the tech boom of the late 90's. This strategy attracts a lot of investors during bull markets because the returns are phenomenal. However, most of the converts switch back to their old strategy after the next bear market. Wanna-be Momentum Investors that don't have proper risk management strategies in place get crushed in Bear markets. Why? Because they only bothered to learn half the strategy, the buying hot investments part, they didn't bother with risk management. If you're going to try Momentum Investing, for your own sake, master the entire strategy!

Investor Profile

Investors that are looking for big winners, like to trade a lot, and prefer aggressive strategies will be drawn to Momentum Investing. This is an attractive strategy for those that feel buy-and-hold strategies are tedious, boring, and less likely to provide stellar returns. Momentum Investors also have to buy into the theory that owning the today's strongest investments outweighs the benefits of asset allocation and diversification. This is a tough sell, we believe individual investors should always hold a balanced portfolio but some Momentum Investors have proven that their strategy can be incredibly successful.

Momentum Investors need a high risk tolerance, they are guaranteed to take losses during bear markets. Risk management helps, but it's the toughest part of the strategy to master. Momentum Investors have to react very quickly when the market turns against them.

This is not a good strategy for the Casual Investor, Momentum Investing takes a lot of time, you have to monitor your portfolio and the market daily. This is also a poor choice if you lack confidence in your investing abilities or prefer to have a lot of time to analyze information before making a decision. Momentum Investors will have to make fast risk management decisions based on limited information when momentum shifts or the market turns bearish, so they need a lot of self-confidence.

This strategy is a market beater if you master it, but not many people do. Two names you may recognize are George Soros and Janet Brown. Soros is famous for breaking the Bank of England and generally disrupting currencies around the world, not to mention providing investors a 3,365% return over a 10 year period in his Quantum Fund. Janet Brown is another remarkable example, she is the only Momentum Investor I know of that has beaten the market soundly for 20 years and counting. These are two of the most disciplined investors you will ever meet and they have to be, Momentum Investing is a demanding strategy.

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