Traditionally stock market investors attempt to buy stocks that are considered undervalued or cheap and then sell when they become expensive. To choose stocks the investor might assess a company’s balance sheet, management, business and economic outlook. From there they must await share prices to fall to the ‘cheap’ levels followed by a turnaround. This all takes time and considerable effort, and in many circumstances requires the ability to make accurate forecasts about future events.
Sometimes those cheap stocks never turn around but instead keep getting cheaper, cheaper, cheaper until they become a very expensive loss. Remember Lehman Brothers? Investors had a slow ride from over US$80 down to bankruptcy over a period of about 18 months.
Below is an Australian stock, ABC Learning. Many Buy and Hold investors ‘bought the dip’ around Aug-Sept 2007, rode the price to over $8 in Nov 2007, hung on whilst the stock turned down, bought some more as they were ‘cheap’, waited for the price to turn around, bought a few more because now they are REALLY cheap…gone.
Figure 1: Buy and Hold or Buy and Hope?
Is there another way? A way that doesn’t involve understanding what the company does, what the future holds and a process that better utilises the time value of money?
The answer is yes – momentum investing.
As simplistic as this may sound, profiting from the stock market stems solely from a favourable price move between the purchase and sale. Regardless of the tools you use to evaluate the market, such as value, fundamental or technical analysis, you only make money when the price moves up. And so with momentum investing, the sole driver of the decision making process is price itself.
Catching price momentum is like a hitchhiker catching a ride. A hitchhiker solicits a ride by standing beside the road; thumb out while facing the oncoming traffic. When looking to capture a ride, hitchhikers don’t know which car will stop or how far a ride will take them should a driver offer a lift. A hitchhiker simply goes with the flow but will only join a ride that is heading in the right direction.
Figure 2: A hitchhiker catches a market wave only after a low is made.
Likewise, as demonstrated in Figure 2, a momentum investor will tend to stand aligned with oncoming price action ready to buy as prices are rising and ready to exit when prices start falling. A momentum investor does not attempt to predict which stock will offer the next ride or how far the ride will take them. A momentum investor, like a hitchhiker, simply goes with the flow of the market: fully invested as the market rises in a sustained up-trend and reverting to cash in a sustained bear trend.
Not every stock will trend all of the time, but there are generally enough stocks trending some of the time to present opportunities. In certain market conditions these rides, or trends, will be very long and extremely rewarding. In other market conditions they may be short and non-rewarding.
A momentum investor will take the good with the bad knowing that, over time, the good outweighs the bad by a significant margin due to the creation of a positive mathematical expectancy. Whilst momentum investing works reasonably well most of the time, like any strategy, investment or asset class, it will have periods where performance is lacklustre. It is important to stress that during these times the strategy is not broken and needn’t be discarded. This is a beginner’s trap; to swap from one strategy to another when times get tough.
Most traditional investment strategies, such as buy and hold or value investing, rely on picking the right stocks, or at least the right sector in which the stocks sit. A momentum investor, on the other hand, does not pick the stock, but rather the stock picks the momentum investor. The stock must start trending higher before it becomes a buying candidate. An extrapolation of this is that a momentum investor need not predict the next hot sector, because stocks in a sector that is moving will automatically rise to the top and be presented as a new trend opportunity.
So, let’s compare a value investor to a momentum investor using Figure 3. A Value Investor will buy stocks that are getting cheaper but they then must wait (and hope!) that the stock price will turn around, pass their initial entry price and keep rising. This takes time. On the other hand, the momentum investor only buys a stock that is already rising so there is no time delay, no drag on your capital. A trailing stop follows the stock price up and the momentum investor exits the trade when the stock price starts to turn down.
Figure 3: Value Investor tries to buy bargains, Momentum Investor Buys in an up-trend
So, what’s a momentum investor’s mathematical edge or positive expectancy? It comes from cutting your losses and allowing your profits to run.
Remember: no one ever made a large profit from taking a small profit.
Nick Radge is Head of Trading and Research at The Chartist with 29 years experience in the financial markets. He has authored numerous books on trading and investing with Unholy Grails (2012) considered required read on Momentum Investing. The Chartist offer bespoke advice on technical analysis and momentum strategies. www.thechartist.com.au