Relative Strength: How Does Momentum Investing Work?

Wednesday, Jul 06 2011 by
10
Relative Strength How Does Momentum Investing Work

In Brief

An investing strategy of buying prior winning stocks and selling short prior losers based on the empirical observation that Investments exhibit persistence in their relative performance. As George Chestnutt wrote back in 1965: “Which is the best policy?  To buy a strong stock that is leading the advance or to "shop around" for a "sleeper" or "behind-the-market" stock in the hope that it will catch up?  . … Many more times than not, it is better to buy the  leaders and leave the laggards alone.  In the market, as in many other  phases of life, "the strong get stronger, and the weak get weaker."

Background

Buying winners inherently con?icts with the contrarian philosophy that is part and parcel of many successful investors. Nevertheless, it has long been noted by traders that good performing investments tend to continue to do so, whereas those that have performed relatively poorly tend to continue on the same path.

Momentum investing is not to be confused with growth investing, short-term price acceleration, or general trend following. It usually involves a disciplined, systematic investing style based on relative price strength over a specific (usually 6 to 12 months) formation period combined with systematic entry and exit rules. 

Definition of a Relative Strength Screen

Richard Driehaus is an example of an investor with a heavy momentum bias, blending earnings and price momentum. However, an indicative 'pure momentum' screen might be: 

  • Exclude the most illiquid stocks, e.g. the bottom 25% of stocks based on market capitalisation
  • High relative strength in the last six months compared with the market (top 25%) - relative strength doesn't work over short timeframes, such as one month.
  • High relative strength in the previous twelve months compared with the market (top 25%), with the 12 months being higher than the three months
  • The hold period for investments would typically also be in the 3-12 month range.

Adding value and/or earnings momentum criteria usually increases the screen effectiveness (see below).

Interestingly, this study  showed that individual investors tend to be relatively bad at applying momentum investing strategies effectively, as against professional investors.

How Well Does it Work?

Academics have focused on studying momentum investing properly for the better part of two decades. A study by Hancock found a momentum strategy outperformed a broad universe of U.S. stocks by nearly 4% per year from 1927-2009.

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Disclaimer:  

As per our Terms of Use, Stockopedia is a financial news & data site, discussion forum and content aggregator. Our site should be used for educational & informational purposes only. We do not provide investment advice, recommendations or views as to whether an investment or strategy is suited to the investment needs of a specific individual. You should make your own decisions and seek independent professional advice before doing so. Remember: Shares can go down as well as up. Past performance is not a guide to future performance & investors may not get back the amount invested. ?>


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4 Comments on this Article show/hide all

Mark Carter 6th Jul '11 1 of 4
2

Readers might also find the following PDF interesting: 52-week high and momentum investing.

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Dave Brickell 6th Jul '11 2 of 4
1

In reply to post #58009

Interesting paper, thanks. I see they also found in subsequent industry-level work this year that "A strategy that buys stocks in industries in which stock prices are close to 52-week highs and shorts stocks in industries in which stock prices are far from 52-week highs generates a monthly return of 0.60% from 1963 to 2009, roughly 50% higher than the profit from the individual 52-week high strategy in the same period".

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emptyend 6th Jul '11 3 of 4
1

Data-mining will "show" almost anything, Dave.

I am now old enough to have done some of the work into various "effects" (small company effect, January effect etc) back in the 1980s. It is observable that these "effects" cease to have much effect once their alleged existance has been highlighted.  As a result, I conclude that almost all the claims that "XYZ approach is superior to ANOther" are the result of temporary anomalies and are incapable of worthwhile exploitation.

I would also add that the recent advent of high-frequency trading and the dominance of unregulated hedge-funds in the investment landscape are matters which IMO render virtually all historical performance comparions utterly meaningless.

ee

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Dave Brickell 6th Jul '11 4 of 4
1

Thanks EE. We're going to be putting all these "investing gurus" / academic theories to the test as part of the Stockopedia Premium data product, launching later this summer, so it will be interesting to see how they stack up. Our initial work in this space suggests some rather interesting results in certain cases, but it's very very early days. Watch this space!

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