In reality this is not always the case. For example on the financial markets, with the Momentum, a phenomenon that is both simple and incomprehensible. But that in fact proves to be an effective investment strategy.
WHAT IS THE MOMENTUM
Well-performing investments tend to continue to perform well, while bad-performing ones tend to go downhill: this is the Momentum (also known as “Price Momentum”). We are therefore talking about the persistence of the trend - both positive and negative - of performance inertia, mostly in the short to medium term.
Momentum can be:
– relative – investments that have recently outperformed others will most likely continue to outperform;
– absolute – (or “Time Series Momentum”) investments that have recently achieved positive performances will likely continue to do so (same with negative performances).
Measuring and using the Momentum is easy: usually the performance over 3, 6, 12 months is considered, after which investments with the best Momentum are preferred. Based on my experience, the 3-month and 12-month performances are the most used to measure the Momentum (not incidentally, they are also the ones on which we base ourselves in AdviseOnly, together with fundamental indicators, i.e. the Value ones).
BUT THIS MOMENTUM WORKS?
I believe that the Momentum is one of the strongest financial phenomena on the square. Widely used by managers and traders around the world, it is a workhorse of many hedge funds, and is well documented in the academic literature. Momentum uncritically and generously pervades the entire universe of investments: stocks, bonds, commodities, currencies. At the level of individual financial instrument and asset class.
I show you a graph that speaks for itself, with data taken from the legendary Credit Suisse Global Investment Returns Yearbook 2017 by Elroy Dimson, Paul Marsh, Mike Staunton of the London Business School. The key fact is this: From 1926 to 2016, a strategy that favors US stocks with the best momentum returned an average of 17,5% per annum (sic). If he had invested in this portfolio, financing its purchase with the sale of the shares with the worst momentum, he would have brought home a good return of 7,4% on average per annum (with a decidedly lower risk than that typical of a equity investment: it is the classic long-short strategy, i.e. you buy securities by financing the purchase with the sale of others). That's no small amount, 7,4% per year…
If you want some academic comfort, among the myriad of articles on Momentum, a classic is this one, relating to US stocks: using data from 1927, the study shows how the Momentum calculated using performances between 3 and 15 months allows to obtain significantly better than the market. Another study highlights the presence of “significant Time Series Momentum'' in equity indices, currencies, commodities and bond futures, as well as the excellent behavior of a diversified portfolio that invests according to the Momentum logic. Another very interesting work shows how Momentum pervades the entire spectrum of asset classes, and is uncorrelated with Value investments, ie based on fundamentals. But, I repeat, there is plenty of empirical evidence in favor of the Momentum. The point, if anything, is another.
WHY DOES MOMENTUM WORK?
I too often wonder: investing according to a Momentum strategy seems too stupid to work. It smells like foolishness. If you think about it, it means that trends continue much further and much longer than a sane person could reasonably think. The academic world obviously adores the topic and discusses it, offering as usual colorful explanations (clinging to rather puny regressions). The main ones are two:
1) fundamental explanation – Momentum strategies are riskier and the extra performance they offer compensates for this additional risk (it must be said that, given the data in hand, this theory is not very convincingly reflected in the data);
2) behavioral explanation - not all investors are perfectly informed, some are slower to act and proceed by imitation, based on what they hear, see and read around (behavioral finance experts speak of "herding"). That is, they behave like sheep in a flock, buying when others buy, and selling when others sell, perhaps on a wave of emotion. This is the explanation prevailing today. And perhaps even more plausible, knowing a little about the trend of the financial markets and the short-sightedness that characterizes the Sapiens.
I've been using Momentum and Value strategies for a lifetime but, I confess, I'm uncomfortable with Momentum. Value strategies, yes, those that are full of common sense: you "buy low" an asset class or a security with solid fundamentals, and you wait for it to go up, showing its value on the market - a bit like going for sales. Instead, with the Momentum, the doors to a demented world open: it is a question of believing that, when the price of an asset is already high compared to the fundamentals, someone will happily buy, causing the price to rise even more. In information documents for investors it is mandatory to write that the past performance of an asset is not indicative of future performance... and instead the Momentum strategies are based on the fact that they are indicative, at least in the short to medium term. It's the world of the Mad Hatter. A small miracle of stupidity, a symbol of human carelessness and emotion, of a large portion of the behavioral biases identified by psychologists. It goes hand in hand with the aptitude for following absurd fashions, for doing things and going to places just because they are trendy. After all, if you think about it, the Momentum is the essence of Homo Sapiens.
The fact is that Value and Momentum are sides of the same coin: in the short-medium term the Momentum (emotions) dominates, but when prices go crazy, the fundamentals prevail, i.e. the Value logic (rationality, common sense) – as heuristically illustrated below .
Often the correction associated with Momentum strategies is brutal, triggered by sudden and unexpected shocks, with the risk of sudden, violent losses (here you can find an example). That's why Momentum strategies aren't for everyone – they require continuous monitoring of the market and associated risks. Otherwise we get hurt. Quite a lot too.
