When it comes to investing styles, two usually take all of the attention: growth and value. However, momentum investing is just as profitable, in my opinion. In fact, I think it could be argued that momentum investing is better than both the growth and value styles. Over the record bull runs of the past decade, we've seen how momentum investing can dominate in optimistic equity markets.
The benefits of momentum investing
Anyone who has been long the S&P 500 or a basket of large tech stocks will have made money without any real fundamental analysis following the financial crisis. All they had to do was buy and hold the stocks and let the market take care of the rest. Momentum has only accelerated over the past 12 months. The success of this "someone else will pay a higher price" strategy has made all other styles of investing look silly in some ways.
But this isn't the first or only time momentum has beaten value and growth. In the 2015 book "DIY Financial Advisor: A Simple Solution to Build and Protect Your Wealth" by Wesley R. Gray, Jack R. Vogel and David P. Foulke, the authors presented the returns of value and momentum strategies against the S&P 500. From July 1963 through December 2014, the S&P 500 produced a 10.2% compound annual growth rate. A pure value strategy returned 15.7% and a pure momentum strategy returned 18.9%. A 50/50 portfolio of value and momentum returned 17.7% on a compound annual growth basis.
These figures are staggering. The study looked at companies with a minimum market capitalization of $1.9 billion listed on the New York Stock Exchange during the period under review. So, these weren't small, hidden growth or value stocks. They were large-cap stocks any investor could have acquired or tracked.
Still, these figures don't show the whole picture. The statistics displayed were so-called "raw" returns. They excluded costs and charges an investor might have to pay. They also assumed the portfolio was rebalanced every month. With annual rather than monthly rebalancing, the outperformance of momentum vs. value declined to just 1.4%, as momentum stocks don't necessarily have the fundamentals to back their prices over the long run.
The drawbacks of momentum
Despite how well it can work in certain situations, we also need to consider the drawbacks of the momentum strategy. Momentum seems to work if pursued consistently with a disciplined approach over an extended period. That may be suitable for some investors, but it may just be too much work for other investors. Like all investing styles, it tends to work only if applied consistently, rather than switching between styles based on the current state of the markets.
What's more, when momentum stops working, it really stops working. Quantitative funds, which generally follow a momentum style strategy, were caught hugely off guard in last March's sell-off. At the time, it was impossible to predict the rapid recovery that followed, but if there weren't a recovery, momentum would still be suffering. How many investors would be able to push through that drawdown and carry on momentum investing on the other side?
The problem with momentum is the fact that it is based on the single principle that there is always going to be someone who is willing to pay a higher price for stocks that attract investor optimism. There's always going to be a huge element of speculation in this equation. That's fine if one is aware and prepared for the risk that there may not be another trader on the other side willing to take the bet one day.
The big difference between value and growth investing and momentum investing is the fact that value and growth both involve working out the intrinsic value of the underlying business first. This can provide an anchor point in uncertain times. In periods of market uncertainty, one can be sure that the business they own is worth a certain amount, no matter what the market says.
Disclosure: The author owns no share mentioned.
Read more here:
- The 1 Simple Rule Required to Be a Great Investor
- Peter Lynch's Advice From 1993 Is Still Relevant Today
- How Charlie Munger's Long-Term View Helped Him Navigate the Mid-70s Bear Market
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