Momentum is an extremely powerful investment strategy. Although it struggles in a choppy market like the kind we saw last year, momentum investing has its charms. As with any investment strategy, diversification is the key. But not just any diversification.
The basic idea of momentum investing is that strong performing investments tend to continue to do well for a while, based on investor psychology.
When an asset class starts to move from a downtrend to an uptrend, the “smart money” gets in first. The “not as smart, but still pretty smart money” follows, then comes the “still smart, but not quite as smart,” and so on until the inexperienced investor enters somewhere near the top.
This cycle generally plays out long enough for the momentum investor to get in once the uptrend starts, get out once a downtrend is established and still make a lot of money on the trade.
Hundreds of research papers show that momentum works across asset classes and time frames. However, just like any investment strategy, momentum can cycle in and out of favor due to different market conditions.
Every strategy has an Achilles’ heel. For buy and hold, it is a bear market. For momentum, the worst type of market is a choppy one, which creates a number of head fakes that trick investors into buying and selling at wrong times.
An asset class might move up for one period, tempting momentum investors to enter, and then move down the next period, causing them to exit with a loss. Repeat this cycle over a year or so, and the experience is pretty frustrating when investors always seem to be buying high and selling low.
Investors, who tend to be less forgiving of losses when the market is up, can abandon a strategy and miss out on the future benefits after a negative year, even though the strategy does exactly what it is supposed to, like momentum in 2014.
The answer to this problem is diversification – not diversification by asset class (large-capitalization and small-cap, international stocks, bonds, etc.) – but diversification by methodology.
Option 1: A core and satellite approach. Investors have a fixed core of a portfolio surrounded by a momentum-based satellite.
In a choppy market, the momentum overlay would still suffer from head fakes, but the fixed core would remain invested. In a bear market, the approach exposes investors to higher drawdowns, but losses in a down market is psychologically easier to tolerate.
Option 2: Multiple momentum approaches. Many tactical managers try to optimize the one best momentum methodology. A smarter approach is to combine multiple, uncorrelated methodologies together. When one is subject to momentum head fakes, the others are not.
Every investment strategy has an environment that it works less well in. Just because momentum strategies struggled in 2014 doesn’t invalidate their effectiveness. We should constantly innovate as much as we can to find the best possible approaches to managing our investments.
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Matthew Tuttle, CFP, is chief executive of Tuttle Tactical Management in Stamford, Conn., and the author of How Harvard & Yale Beat the Market. He can be reached at 347-852-0548 or firstname.lastname@example.org.
Nothing in this article should be interpreted to state or imply that past results are an indication of future performance. Please consult your tax or investment advisor before making any investment decisions.
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