There is a positive correlation between the historical stock price and future price performance, also known as the momentum effect, which is a hot topic in the academic circles recently. Although we still do not know the cause of the momentum effect, relevant research holds that buying up and selling down is a very effective investment strategy.
For this reason, many investors use momentum indicators when picking stocks, and some also hire investment managers who use momentum investing strategies to manage their money. This article will introduce you to some of the possible downsides of momentum investing and how to use it to get the most out of it.
In the stock market, momentum indicators can play a huge role, but only if you make the right judgment up front. In the two situations listed below, momentum is instead a drag on your investment performance.
In a volatile market, it can be said that a market with a stable development and a clear trend is the best partner of a price momentum trading strategy, and market volatility is its worst enemy. In the academic paper “Momentum—A Contrarian Case for Following the Herd” published in 2010, Dr. Tom Hancock studied the historical returns of momentum investment strategies, which he believes can represent the main momentum investment strategies that are popular today. Its investment return profile outperformed the overall performance of the U.S. stock market by nearly 4% over the 1927-2009 period, but it also had some problems.
Dr. Hancock noted that the strategy performed poorly in the six months following the peak of the bull market and the peak and trough of the bear market, and it also performed poorly during periods of high stock market volatility. There are other studies showing that momentum strategies perform better in rising markets than in falling markets.
Dr. Hancock finally concluded the following: “Since market volatility implies mean reversion rather than the next move of the stock, momentum trading strategies are not suitable for volatile markets. Of course if you can predict the future volatility of the market or the coming of a bear market, you can definitely predict whether the current momentum indicator is effective. But if you really have that ability, you don’t need to rely on the momentum indicator to profit.”
It is difficult to predict when the market will become unstable and when it will reverse. But once you know when momentum investing strategy might fail, you can better interpret your investment performance. At the same time, you can also easily identify those investment managers who use momentum investment strategies as easily as you look for value investment managers.
When using value investing strategies, value investors tend to ignore crowd effects. Research shows that stocks with very attractive valuations, such as stocks with low price-to-book ratios, do not necessarily have positive price momentum. For this reason, pure value investors often find themselves gravitating toward stocks with positive price momentum, but in doing so, it may take a while for their portfolios to be profitable.
In the March/April 2005 issue of the Journal of Financial Analysts, Alan Scowcroft and James Franco published an article titled "Understanding Momentum," where they identify the drivers of stock price momentum and provide an invaluable solution for value investors.
They point out that, for large-cap stocks, share price momentum is primarily driven by the industry the stock is currently in rather than the momentum of individual stocks. Scowcroft and Franco concluded: “For value managers, they can hold a cross-industry stock portfolio, which will dilute price momentum and ensure better investment liquidity.” They also believe that holding a cross-industry stock portfolio can also avoid the long-term risks that momentum changes may bring.
In the stock market, we need to understand the possible negative effects of momentum indicators in order to better improve our investment performance and reduce investment risks. Historically, momentum investing strategies are also somewhat volatile and have a high turnover rate, but compared to traditional value investing strategies, they can help us spread risk better. Investors can profit from momentum investing strategies, but they must be used properly or they can backfire.