The positive relationship between a stock's recent price history and its future price performance - known as the momentum effect - is one of the most heavily researched stock market anomalies. While the jury is still out regarding what causes the momentum effect, studies have shown that buying the stock market's recent winners and selling its recent losers can be a rewarding (albeit volatile) investing strategy.
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For this reason, many investors incorporate price momentum indicators into their stock selection process or hire investment managers to employ momentum-based strategies. Read on to learn about the possible downside of price momentum investing and how to get a grip on the effects that momentum could have on your investment portfolio. (For related reading, also be sure to check out Riding The Momentum Investing Wave.)
Stock market momentum is a great thing, but only when it is working in your favor. Below are three situations where momentum could throw a wrench in your investment performance.
When Investing In a Volatile Stock Market
If a smooth, trending stock market is a price momentum strategy's best friend, a volatile market is its worst enemy. In a white paper titled "Momentum - A Contrarian Case for Following the Herd" (2010), Dr. Tom Hancock studied the historical returns of a simple momentum-based investing strategy which he believed was a good proxy for the range of momentum strategies used today. While the strategy outperformed a broad universe of U.S. stocks by nearly 4% per year from 1927-2009, its performance was not without some hiccups.
Dr. Hancock reported that the strategy had poor relative performance in the six months following recent bull market tops and bear market bottoms. He also found that it suffered during periods of high stock market volatility. Other research has shown that momentum strategies perform better in rising markets than in falling markets.
Dr. Hancock came to the conclusions that, "Volatility is bad for momentum, largely because volatility is associated with mean reversion and not trending. And if one can predict volatility or a bear market, that no doubt has power predicting whether momentum will succeed. But the ability to make those calls with some precision about the timing is a skill that allows one to profit in simpler ways."
Predicting when the stock market will become volatile or have a major directional change is very difficult. However, knowing when momentum strategies may suffer can help you better understand your investment performance. It can also help you identify investment managers that will complement a momentum strategy, like value-based investment managers.
When Using a Value-Based Investing Strategy
Value investors tend to ignore the herd. Studies have shown that stocks with attractive valuation characteristics, like low price-to-book ratios, are not likely to have positive price momentum. For this reason, pure value investors often find themselves under exposed to stocks with positive price momentum characteristics. This can lead to a portfolio of stocks that languishes for long periods of time before recovering. (For more on the herd mentality, see Run With The Herd Or Be A Lone Wolf?)
In a study published in the March/April, 2005 Financial Analysts Journal titled "Understanding Momentum", Alan Scowcroft and James Sefton break down what drives the performance of stock price momentum strategies and offer a solution to value investors.
They report that, when it comes to large-cap stocks, price momentum is largely driven by the momentum of a stock's broader industry sector and not by the momentum of the individual stock itself. Scowcroft and Sefton come to the conclusion that, "Value managers could reduce the possibility of underperformance as a result of underweighting momentum by holding a sector-neutral portfolio." They also suggest that holding a sector-neutral portfolio could reduce the long-run portfolio risk arising from changes in momentum.
Constantly monitoring whether or not your stock portfolio's industry sector weightings are neutral with a benchmark index, like the S&P 500, may not fit your investment philosophy and process. However, if you are concerned about relative returns, it is important for you to be aware of your stock portfolio's industry sector weightings relative to your respective investment benchmark. This is especially true if you own a portfolio of large-cap stocks. The information in this study may also suggest that pure momentum-based investors would be better off using industry sector funds rather than individual stocks to employ a momentum investing strategy.
When Investing In a Taxable Account
Momentum-based investing strategies generally have high portfolio turnover rates relative to other strategies, which can lead to higher transaction costs and excessive short-term capital gains taxes. Critics have argued that these costs could eliminate any excess returns that momentum investing strategies could offer versus simply buying a broad stock market index. To combat this issue, allocate investment strategies with higher portfolio turnover rates to tax deferred accounts. This will help you minimize taxes and maximize your investment returns.
The Bottom Line
When investing in stocks, understanding the downside of momentum can increase your investment performance, minimize investment risk and lower your tax bill. History suggests that momentum investing strategies can be volatile, require high portfolio turnover and have diversification benefits relative to value-based investing strategies. While investors can benefit from momentum-based strategies, having too much invested in these high flying strategies at the wrong time could create major headwinds for your investment returns. (For related reading, also take a look at Momentum Trading With Discipline.)