The Challenges of Investing Using Momentum

Investing

We may see how much certain stocks have moved up and wonder why the funds that we invest in to seek to capture some of this don’t do anywhere near as well.

Most people who invest in funds that segregate their holdings, in other words do something else besides just investing in the broader market such as the S&P 500, do not realize the challenges that these funds are up against. They may think that it’s just as easy as investing in a fund that targets what’s hot right now and they should be able to handily beat the overall market and have our portfolios soaring.

It is not anywhere near as easy as this though, and funds face some unique challenges that we don’t if we’re looking to put together a list of stocks like they do. Individual investors don’t generally know much about what they are doing though, and this is what makes going with a professionally managed fund so appealing, at least on the surface.

A lot of investors are under the belief that picking stocks involves some pretty arcane stuff, and this may even be beyond our ability even if we devote all of our time to this. Funds have a team of people who work full time on these things, and they are also trained to do so, where we may only have a few minutes a day that we want to spend on this and usually prefer we spend no time at all beyond perhaps just looking at our account statements to see how much we made or lost last quarter or last year.

The industry wants us to think exactly that, because then they have us, and do-it-yourself investing is strongly discouraged. In some cases, in a lot of cases perhaps, it should be discouraged, at least the kind where we just jump into this with no real skills and expect to do well.

We generally have no interest in any of this, which is fine, and there are plenty of people ready to help out by managing your money along with those of a lot of other people, where all the money gets pooled and then they decide how it is to be invested. At the very least though, we need to be aware of the limitations of such a scheme so our expectations are brought more in line with reality and we can then also make an informed choice about how we wish to see our investment money managed.

Funds have various objectives, which are stated in their prospectus, and there are funds out there that seek out a number of different strategies, from money market funds that invest in only the safest investments, to funds covering the riskiest segments of stocks, and everything in between.

Momentum Funds Can Be a Good Choice if We Know Their Limitations

One of the options out there is to invest in a momentum fund, which seek out stocks that are performing well, and therefore offer the promise of continuing this. Stocks that perform well in a bull market are those with what we call a higher alpha, which means that they move more in both directions than the market does.

What momentum stocks do is look at how a stock has performed over a fairly recent time frame, such as 6 months or a year, and the ones that have done well become candidates for the fund. This is not a bad approach at all and certainly has more potential than how funds normally decide what stocks to add, which usually depends on factors other than performance actually.

It is certainly better to make these decisions based upon actual performance rather than just belief, as these beliefs are often mistaken and are at best quite removed from reality. An example of this approach would be to look at how much a stock costs relative to its earnings and assume that this means it should perform well.

This is often not the case though and quite often, the reason why a stock is such a good value is because the market is not so fond of the stock. If they aren’t fond of it now, especially in a bull market, it’s more likely than not that they will remain out of favor with it in the future as well, keeping this ratio low, for a variety of reasons, not the least of which is their future prospects not being as bright as stocks which appear to have less value.

The first step, if we’re looking to build the ideal fund, is to cast this off and pay attention to what a stock is actually doing. This is what we call performance, and the continuation of good performance, or bad performance if it’s going down, is called momentum.

This is only part 1 of the deal though, and if performance is going to be the criterion to cause us to like a stock and want to own it, continued good performance is at least as important, and it’s actually more so because if it doesn’t, this means real losses on our part if we hang on from the green into the yellow and then well into the red.

Today’s hot stocks can become tomorrow’s biggest losers pretty easily, for instance when the market turns and things reverse course. Now, our higher alpha stocks cost more to hold, and these are the last stocks we want to be in when this happens. The tendency with both funds and individuals is to want to hold these plays too long, and there is a potential of getting into a slippery slope where you lose more and more and each time you think that it may turn around soon.

Before too long, you’re behind a lot and then are really thinking that if you get out now you will miss out. This fails to account for our being able to re-enter any time we want, but if we do that, the timing of our re-entries must make sense and we cannot use the same whimsical approach as the people who hold them too long use, where we sprinkle generous amounts of hope in.

While we may jump in too soon, we may also become too defensive, especially after losing a bundle on a stock. We might think that this thing needs to show us a lot before we will play it again, and after it does, we may think that perhaps it’s too late and then just watch it go up a lot more without us.

The month of May provided a good example of how challenging these decisions can be. The overall market declined 6% last month, while tech stocks gave back 10% on average. Should we have been in tech stocks last month? Should we have been in stocks at all last month or at least during the part of it where the momentum shifted?

A trader wouldn’t be asking these questions, because traders just ride the wave, at least the ones that do well at it. There is always a lag when looking to time stocks, and the lag consists of how much room we give them in the other direction prior to closing our positions.

Traders trade their positions much tighter than investors do, and investors can’t just jump off every time the market moves down a little or their stock prices back up because this would require that they trade with much greater frequency than they desire or perhaps are prepared enough for.

Trading Momentum Takes Some Real Skill to Do it Well

This is not to say that investors trading on momentum isn’t a good idea, it’s just that what constitutes a reversal in a trend is going to need to be significant, to limit the number of trends during a given period.

If we are trading over short term timeframes, there may be dozens or even hundreds of distinct trends in a single day, and these are far from significant enough for any investor to want to pay attention to. People do trade these trends quite successfully though, and can put in more trades in one day than most investors will take in their lifetimes, but investors don’t spend their day watching charts and moving in and out of stocks very quickly.

This does not mean that we should be setting static thresholds though, for instance setting a moving stop at 20% and getting out when we reach that. That actually may be too much room even for an investment, although the 6% we lost in May would not be unreasonable for an investor who is choosing wisely.

Momentum funds have to meet all these challenges, but at least someone is behind the wheel that knows more about what they are doing than we might. There is one thing that funds don’t do that well though, and an additional challenge that we do not have, and that’s the lag between the decision to get in and out and the time that the move is fully put into play.

With such large orders, they can’t just move in and out of positions like we can, as this takes time. We therefore have what we could call the reversal lag, as they do, and they also add what can be called the execution lag.

What this execution lag serves to do is to delay both entries and exits, where they have to increase the threshold to both get in and out. If getting in and out of positions takes longer, you have to do less of this, and give these plays even more room than we would otherwise. This means less efficiency with capturing trend moves, as well as poorer fills due to the time lag between the decision to buy or sell and when you’re in.

Fast moving stocks increase this risk, because more happens over a given amount of time. This is especially an issue during a downward turn, as prices tend to move more quickly that way and if we are in stocks that move more than average, we can get stuck a lot more.

This can lead to situations where a momentum fund may pare down their holdings in a poorly performing sector, such as health care stocks right now, and the sector may be underperforming for a good while before they finally unload them all. This isn’t all bad though as beaten up stocks can lose less during a market pullback, and in May, this sector only lost 2.6% for example.

The main takeaway here is that we don’t just want to assume that momentum funds will just beat the market and beat them in the same way as we might be able to do if we stick with better performing stocks and cut them once they stop. This is not as easy to do for us as we might think, and even harder for a fund to pull off.

If we do get ambitious enough to do this on our own, we are going to need to make sure that we have what it takes to do this, and most of the challenge is on the psychological side actually. We might read a book about flying an airplane, but being in the seat, with the risk of death if we’re not careful, can be a different story.

Real pilots learn on simulators though and that’s how stock pilots need to learn how to fly as well. If we are dissatisfied with the performance of our funds and think we can do better, we need to show ourselves the money before we can claim this with any confidence.

Momentum funds can be a good choice at times, in a bull market for instance, although they don’t do so well in pullbacks. There is another choice though and that’s letting the professionals do all the nitty gritty work and just decide whether the weather is good enough to fly right now, and if not, get off the plane and wait for a better time.

This still isn’t so easy to decide, but at least it doesn’t require so much effort, even though it still requires sound judgement and never underestimating the challenge.