A large part of the investing community appears to have complete disdain or disregard for momentum, either treating it on a par with divination through chicken entrails or disinterestedly accepting its existence but with a ‘not for me’ attitude. While there are many ways to skin a cat, given the overwhelming weight of evidence finding excess returns to momentum this has always seemed rather narrow-minded to me.
While logically one wouldn’t expect to observe momentum if markets were efficient at processing information, the same could be said of value. It strikes me as strange that some investors are so willing to attempt to exploit one manifestation of market inefficiency (that shares may be temporarily undervalued and then ‘revert to mean’) but may be so reluctant to exploit another (that share prices which have risen more in the past will tend to rise more in the future). This is despite momentum being far easier to measure than value.
I think this is because the reasons behind why momentum works are slightly counterintuitive. They are much less instinctively attractive than the simple idea of seeking a bargain, which is biologically hard-wired into us. In my view this makes momentum following a more contrarian strategy than value investing. The drivers of momentum (of which there are several) are actually quite compelling if you take the time to think about them carefully.
Why does momentum work?
The reasons for momentum most commonly cited relate to behavioural psychology – broadly the idea that investors don’t respond to the price in a purely objective way (i.e. is it less than how much I think the business is worth?) but are biased by how it is framed. There are several powerful behavioural biases that may lead to momentum:
- Anchoring: investors’ perceptions of value are affected by the ‘anchor’ of the existing price. Relative value is easier to assess than absolute value so we are naturally disposed to (subconsciously) use benchmarks to make complex quantitative assessments. Experiments have shown that when arbitrary benchmarks are introduced, they can cause massive biases to completely unrelated assessments, as people subconsciously automatically latch on to the nearest available benchmark. When assessing the value of a share the most obvious benchmark is the current price. Something that has just risen by 10% will subconsciously appear to be expensive while something that has fallen by 10% will look cheap, regardless of the actual price. The implication is that share prices will tend to under react to news affecting the share price in the short term but then slowly adapt to the information properly over time. This leads to momentum.
- Loss aversion and the disposition effect: investors are much more sensitive to whether they win or lose than to the amount they win or lose. This means that they are prone to snatch profits to crystallise wins quickly but hold on to losses in case they turn around. Similar to anchoring, this can mean that it takes longer for shares to reach their true values, leading to momentum over time. Many professional gamblers and investors have learnt to exploit this bias by employing the contrarian strategy of winning less frequently but in bigger amounts (betting on the longer odds). In investing this translates to the cardinal rule of: Run winners and cut losers!
- Regret aversion: this is a similar but slightly nuanced effect. Investors are put off buying a share that has risen in price because this makes them regret not having bought it sooner. Rather than admit their imperfection and buy (better late than never), it is easier to simply ignore the existence of the share. Similar to the previous effects this means it may take longer for a share to reach its true value.
- Herding: unlike the other effects which all provide reasons for share prices to under react to positive news, herding provides a reason for share prices ultimately to over react. The idea is that investors copy one another because they don’t want to lose out or because they treat the rising price as a signal of value. You could think of this as ‘bad’ momentum, as ultimately it will lead to overshooting and a subsequently falling share price when eventually the bubble bursts.
These are all very real and powerful effects whose existence has been demonstrated time and time again in experimental settings. Collectively I believe them to be very strong drivers of momentum – but they are not the only drivers.
Informational failures and liquidity
There are some very simple but quite poignant ways in which markets are not efficient that may lead to momentum. In particular information is not imparted to all participants at the same time. In some cases, certain investors may be privy to inside information (or simply get access to publicly available information more quickly than others). This can lead to momentum. I have observed many occasions when share prices (often of small caps) have mysteriously risen in advance of good news or fallen in advance of bad news. It can pay to heed these signs.
Momentum may also arise simply because many participants are not paying attention all of the time. Reactions to news may sometimes take some time. This also creates issues of liquidity. Large institutions who want to buy in quantity are often unable to do so at once without causing a sharp rise in price because sellers can’t immediately be found. This can lead to the price rising over a sustained period of time.
One of the huge advantages a small private investor has over a big institution is that they have greater liquidity and can exploit this by following momentum quickly.
Momentum can also arise due to the underlying performance of the business. One of the key drivers of momentum is simply the fact that some businesses are inherently better than others. Businesses that do well may have a greater tendency to continue to do well and vice versa.
The nature of this momentum and how the investor should regard it may vary across different types of business. Great businesses will grow substantially in value over time – these should exhibit more continuous share price momentum. Average companies which do not grow substantially in value over time may have share prices which oscillate around their true value – for these it may often pay less to follow momentum.
Because of this, exploiting momentum will work better if you focus on businesses that have enduring advantages that will allow them to continually outperform over time. This is also the core tenent of ‘quality’ investing. The quality investor believes that certain businesses are special because of inherent enduring advantages they possess. Momentum can help identify these higher quality businesses and following momentum is likely to work better in conjunction with other quality factors.
How to take advantage?
It is very straightforward to take advantage of momentum. There are two main ways in which I do so.
First I use it as a factor when deciding which share to buy: I am more likely to buy a share whose price is in an uptrend, hitting new highs and especially one which has recently issued positive newsflow. The latter point is relevant as positive share price momentum with recent positive newsflow will tend to imply that the share price has under reacted to the news and will continue to rise. I also use long term momentum as an indicator of business quality – broadly speaking, if you zoom out to the 10 or 20 year share price graph, a high quality share should have a consistent rising trend rather than be oscillating up and down.
Second I use it as a factor in deciding when to sell. I will often sell if momentum reverses and an uptrend is broken. I will always sell if there is negative newsflow.
So it’s pretty simple really – trading discipline using momentum is one of the most important and easiest way to make (and avoid losing) money in the stock market as a private investor.