Momentum investing has a bad rap.
Over the past 35 years, I've heard it referred to as a "strategy for idiots" or a foolish undertaking on par with a good old-fashioned game of "hot potato"… usually by Wall Street types or academics who look dismissively down their nose at anyone suggesting something different.
The irony, of course, is that momentum investing works.
What's more, momentum investing:
- Is simple to use
- Easy to understand
- Can keep you out of trouble if the markets roll over
The premise is very straightforward.
Stocks that are doing well continue to do well, and stocks that are doing poorly continue to do poorly – which is why, of course, you buy the former and sell (or avoid) the latter.
Critics charge that such a simple concept can't possibly work in today's complicated financial markets. And, having bought off on that line of thinking, most investors are deeply skeptical.
But again… momentum investing works.
A 2014 study in the Journal of Portfolio Management by Clifford Asness, Andrea Frazzini, Ronen Israel, all of AQR Capital, and Tobias Moskowitz of Yale University, showed that momentum investing averaged 8.3% a year from 1927 to 2013 versus barely half of that – just 4.7% – from value stocks.
That's a 2-to-1 advantage and enough to turn every $10,000 invested and compounded into a $4.2 million versus only $330,000 from value investing, one of the most widely documented strategies and Warren Buffett's favorite, by comparison.
Other studies reflect similar results, my point being that this isn't a one-off nor am I cherry-picking data.
Technical traders attribute momentum to a constant series of reactions between overbought and oversold conditions. Behavioral scientists think that momentum is a feedback mechanism driven by social behavior and emotions like greed and fear.
My take is that the truth is somewhere in between – that momentum exists and has a very real impact on profits is irrefutable.
Keith is wagering nearly $10 million that average gains of 313% PER WEEK (including partial and full closeouts) are possible whenever this pattern appears in regular stocks. Click here for more details…
Professor Eugene Fama of the University of Chicago's Booth School of Business even went so far as to call momentum "the premier market anomaly," noting that stocks with "low returns over the past year tend to have low returns for the next few months and stocks with high past returns tend to have high future returns."
He ought to know.
Fama won the 2013 Nobel Prize for economics for his work on the relationship between risk and expected returns as they relate to modern investment theory.
There are all kinds of ways to measure market momentum, ranging from absurdly simple to formulae so complicated that you'll need a rocket scientist at your side to interpret 'em. Stick with the simple.
The easiest way to measure momentum is a 200-day simple moving average. You'll hear this talked about a lot on financial programs because it's easy to understand and many institutional investors use it as a gauge measuring… you guessed it… momentum.
If markets are above the 200-day SMA, conditions favor buying. If the markets are below it, conditions favor selling.
Using combinations of moving averages like the moving average convergence divergence, or "MACD" for short, is also very popular.
The MACD also a momentum-driven indicator, only it shows the relationship between two or more moving averages by taking the difference of the faster (shorter time frame) from the slower (longer time frame) line.
The shorter line becomes the signal line, meaning you buy or sell as it crosses the longer average because it reflects more "immediate" momentum in the markets as a whole or in specific stocks that interest you.
My favorite momentum indicator, though, is something even simpler.
About the Author
Keith Fitz-Gerald has been the Chief Investment Strategist for the Money Morning team since 2007. He's a seasoned market analyst with decades of experience, and a highly accurate track record. Keith regularly travels the world in search of investment opportunities others don't yet see or understand. In addition to heading The Money Map Report, Keith runs High Velocity Profits, which aims to get in, target gains, and get out clean. In his weekly Total Wealth, Keith has broken down his 30-plus years of success into three parts: Trends, Risk Assessment, and Tactics – meaning the exact techniques for making money. Sign up is free at totalwealthresearch.com.