A FEW WEEKS BACK, a reader—let’s call him Karl—challenged me with a question. Why, he asked, don’t I recommend momentum investment strategies?
If you aren’t familiar with the term, momentum strategies seek to buy stocks that have done well in the past, with the hope that they will continue rising, while also selling stocks that have done poorly, with the expectation that they will keep falling.
Karl asked why, in a recent article, I had dismissed momentum investing as the sort of thing that would turn your portfolio into an “unpredictable stew,” even though research has found that it can be profitable. It’s a fair question.
Karl is right that there’s lots of evidence to support momentum strategies. The most commonly cited paper was published in 1993. Since then, many other academics and practitioners have confirmed that it does indeed pay to buy stocks that have been going up and to sell those that have been tumbling. In fact, there’s enough data to conclude that this really isn’t an open question anymore.
Momentum definitely works. And it’s not limited just to stocks. Momentum also works with bonds, commodities and other types of investments. Indeed, it’s a remarkably durable feature of investment markets. One paper found evidence of momentum going all the way back to 1801. And yet, despite all this research, I still don’t recommend momentum strategies.
Reason No. 1: Costs. Momentum trades don’t last forever. In the 1993 paper referenced above, the authors found that the optimal holding period was just six months. If you want to jump on the bandwagon when a stock is going up, you have to move fast. You can’t wait too long to buy—and you also can’t wait too long to sell.
If you do, there’s a high price to pay: After that six-month holding period, momentum tends to reverse and you could end up worse off. Because of this need to move fast, momentum strategies are expensive. First, all this trading can leave you with a tax bill. Second, trading itself is expensive. In addition to commissions, there are bid-ask spreads. Finally, because so much work is involved, momentum funds are expensive. Even Vanguard Group, with its reputation for low costs, charges four times more for its momentum fund than it does for its standard S&P 500 index fund.
Reason No. 2: Lack of Predictability. Like any niche bet, momentum trading will have periods when it shines and periods when it underperforms. But because momentum is such a risky strategy—attempting to jump in and out when a stock is on the move—it runs the risk of severe losses when the market turns abruptly.
According to one paper entitled “Momentum Has Its Moments,” momentum strategies declined by 73% over the course of just three months in early 2009, when the stock market suddenly turned positive after months of decline. To hedge this risk, you could find another strategy with a negative correlation to momentum. They do exist, and that might moderate your losses.
But that would mean adding two new funds to your portfolio, and you would have the additional question of how to weight them appropriately. And then, of course, you would run the risk of two negatively correlated investments simply canceling each other out. In short, you can have pure momentum, with all the risk it entails, or you could try to manage that risk, but with added complexity and uncertain results.
Bottom line: There’s no question that momentum is a proven strategy. But it’s also expensive and extremely risky. Yes, others might make money with the strategy—sometimes—but that shouldn’t bother you. The purpose of investing, in my view, isn’t to accumulate the absolute greatest number of dollars. Rather, it’s to accumulate the greatest number of dollars, while also meeting your financial goals and sleeping at night.
Adam M. Grossman’s previous articles include Playing Nice, Stepping Out and Math vs. Emotion. Adam is the founder of Mayport Wealth Management, a fixed-fee financial planning firm in Boston. He’s an advocate of evidence-based investing and is on a mission to lower the cost of investment advice for consumers. Follow Adam on Twitter @AdamMGrossman.
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