Momentum investing is a popular strategy in the world of stock market investing, rooted in the belief that past price trends and market performance can provide valuable insights into future stock movements. This approach rests on the idea that stocks that have performed well in the recent past are likely to continue their strong performance in the near future, while those that have lagged behind are likely to continue underperforming. Momentum investing, also known as cross-sectional momentum, is a departure from traditional “buy and hold” strategies and is built on the principle that trends, both upward and downward, can persist longer than anticipated. At its core momentum investing does not try to anticipate an unknowable market future, it simply reacts to what is happening today.
Measuring Momentum
The core principles of momentum investing involve identifying and capitalizing on stocks that are currently displaying strong relative strength (as opposed to absolute momentum), typically over the short to medium term of roughly 6 to 12 months (too short or too long of a time period, mean reversion dominates). There are as many ways to identify relative strength as there are investors; however, the most common methods center on calculating the percent rate of change over N-number of days, or the slope of a regression line of a given lookback period. No matter the method, the simpler the better, as overcomplicated momentum systems with too many filters or too many parameters are prone to overfitting historical data, which results in poor real-time performance.
Once an investor has a systematic framework for measuring momentum, the next step is to apply the measurement to a universe of stocks such as the S&P 500 or Nasdaq at a set time interval (ie every month). After calculating the momentum score for each stock in your universe, an investor needs to then focus on buying the top performers at that point in time (ie the top 10 or 20 stocks based on their momentum score). We do not know how the stocks will react 1 day from now, 1 week from now, or 1 month from now–we only know that they are strong today, and we are betting that they will continue to be strong until something fundamentally changes in the unknown future.
Position Sizing
Next is sizing each position, which can be done as simple or as complicated as one likes. On the simple side, one can simply equally weight each position so that if you select the top 10 stocks, you simply invest 10% into each position. A more complicated position sizing method can incorporate volatility, such that more volatile positions make up a smaller position (ie inverse volatility weighting method). Whatever method you decide on, it is important to apply a systematic method to determine position size so you don’t let emotions interfere with your sizing.
Exiting a Position
Just as we enter a position based purely on a systematic and unemotional process, the exit must follow a similar systematic and unemotional process. Two common ways to exit a position are:
- Stop loss: On entry of the position, you set a stop loss order of X% (typically 15% to 20%), and if the stock hits the stop loss order, it is automatically sold. You can then either way until the next entry period (ie end of the month, quarter, etc.) to replace with a new position, or you can recalculate momentum scores for your universe and select the next stock in your ranking.
- Falls out of ranking: If your system always buys the top 10 strongest stocks at the end/beginning of the month, then when it comes to the monthly rebalancing period, if a stock is no longer in the top 10, it is automatically sold and replaced with the newest member of the top 10 list.
Note, that studies have shown that portfolio reconstruction periods of 1 to 3 months tend to do best as they avoid over-trading while ensuring that losers are quickly sold off and replaced with new winners. The frequency of trading will create taxable events and this has to be taken into consideration when selecting an investing strategy.
Conclusion
Momentum investing is a style of investing that focuses on systematically moving into the strongest stocks and exiting poor performers. By design, momentum investing will never buy the bottom or sell the top as it is a reactive system; however, by its very nature, momentum investing will always avoid catastrophic losses and catch monster movers. An individual interested in momentum investing needs only to design a way to measure strength, apply that method across a stock universe, hold the strongest, and rebalance at a desired frequency.
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