Momentum investing has something of an image problem. It is not particularly sophisticated to say that we are buying a security because its price is going up or selling it because it is going down. It appears far superior to make investment decisions based on the elaborate fundamental analysis of a company or forensic due diligence of an actively managed fund. Despite a somewhat unattractive reputation, however, most of us are momentum investors. We just don’t want to admit it.   

What are the attractions of momentum investing?

In its most simple terms momentum investing is buying assets that are performing well, whilst abandoning the laggards. There are a range of reasons why investors find this secretly appealing:

1) It’s easy: Doing momentum investing badly is incredibly easy. It takes barely any effort to know which asset classes and securities are in-vogue. (Conversely, good momentum investing is difficult, particularly behaviourally).

2) It’s comfortable: Investing in things that are working right now and selling those that aren’t is incredibly comforting. It makes us feel good and worry less.

3) We extrapolate: We cannot help but think that what has happened recently will persist into the future.

4) We build stories around performance: When an asset is performing well, we create stories to justify it. Positive performance momentum leads us to form a compelling and persuasive investment narrative. A virtuous / vicious circle which increases our conviction.

5) We are comfortable in the crowd: Chasing momentum means following the crowd. Not only do we think that crowd behaviour provides us with information; taking a contrarian stance against it carries a host of unpleasant risks.  

6) Our career might depend on it: Momentum investing can be a useful survival strategy in the asset management industry, even if it destroys value over the long-term. Always telling clients how we are invested in the latest flavour of the month areas might just keep us from getting fired.  

Why don’t we admit to being momentum investors?

Despite the appeal of momentum investing, few of us admit to being profoundly influenced by it (excluding those who are running explicit momentum strategies). It is just too simple.

Although the majority of active fund investors chase performance, they rarely acknowledge it as the major influence on their decision making. Even when using a dreaded performance screen to filter a universe of funds (which ingrains momentum into the selection) this will be framed as a minor part of the process, before the more detailed research begins.

It is just not feasible to say to colleagues or clients: “we invested in this fund primarily because it was performing well”, even if this is the case. (We will also inevitably persuade ourselves that positive performance momentum wasn’t the significant driver of our decision).

Why doesn’t being an implicit momentum investor work?

There is a major problem with momentum being our implicit investment strategy – it doesn’t work. We are likely to be wildly inconsistent in our behaviour. Erratic, driven by noise, emotion and perverse incentives. We will be frequently whipsawed and often under-diversified.

Each time we make investment decisions that are implicitly driven by momentum it makes us feel better for a time; but what will feel like short-term wins, almost inevitably compound into painful, long-term losses.  

But momentum investing does work!

Why am I claiming that momentum investing doesn’t work, when it is one of the most empirically sound investment approaches to adopt? Momentum is everywhere.[i] It is because there are two types of momentum investing: implicit (the one we don’t like to admit) and explicit (which we find in academic literature and employed by various quant firms). Explicit momentum strategies are the polar opposite of their implicit counterpart. They are systematic, rules-based, unemotional, persistent and diversified. Everything implicit momentum strategies are not.

People often question why there is a premium for systematic momentum strategies. Perhaps because their profits are the other side of the losses made by ill-judged and widespread implicit momentum strategies. Bad momentum strategies feed good momentum strategies

Implicit momentum, or what we might call performance chasing, is endemic and entirely understandable. Not only are we hardwired to invest in assets that are performing well and sell those that are struggling, but the asset management industry also compels it – all our short-run incentives are aligned to behave in this way.  

There is nothing wrong with momentum investing, but there is plenty wrong with adopting an investment strategy that we won’t acknowledge to ourselves or anyone else.  

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[i] https://pages.stern.nyu.edu/~lpederse/papers/ValMomEverywhere.pdf

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I have a book coming out! The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can find out more here.

It is often said that a useful measure of happiness is the gap between reality and expectations. A similar approach can be adopted for identifying poor investment decisions. They tend to occur when our expectations of what we are capable of exceed the reality. This miscalibration leads us into activities and behaviours that we really should avoid.

Here are some of the most significant examples of what we think we can do, but probably can’t:

1. Time markets: Perhaps the most grievous example of investors overestimating skill is a belief in market timing. This is not just predicting what will happen, but when it will occur. The second part of this equation is even more difficult than the first. Forecasting with any precision the behaviour of a complex, adaptive and chaotic system is just not feasible.
   
   
2. Truly understand complex funds: Complex funds are alluring because they come with outlandish promises of high returns and low, differentiated risks. They also breach a cardinal rule of investing – don’t invest in things we don’t understand.
   
   
3. Predict inflation (or other macro variable): Our inability to accurately forecast macro economic variables seems to have no impact on our willingness to keep doing it.
   
   
4. Pick funds that consistently outperform: The greatest myth in fund investing is that any manager or strategy can consistently beat the market. Even a skilful fund manager will underperform for prolonged periods. When we fail to realise this we get trapped in a painful cycle of selling losing funds and buying yesterday’s winners.
   
   
5. Withstand poor performance: Spells of weak performance are inevitable for any strategy, fund or asset class. These are easy to deal with in theory, but the lived experience is an entirely different proposition. The stress, anxiety and doubts that occur during difficult periods will lead us to make poor decisions at just the wrong time.
   
   
6. Ignore a compelling story: Every bad investment comes with a beguiling story. We think that it is other people that will be taken in, but, one day, it will be us.
   
   
7. Be a long-term investor: The great rewards available for long-term investing only exist because it is so difficult to do. Doing very little feels like the easiest task in the world, but the temptation to act is so often overwhelming. Every day brings a new story, a new doubt, a new opportunity. A new reason to be a short-term investor.
   
   
8. Avoid dangerous extremes: Most of what we witness in financial markets is just noise, but extremes matter. When performance, sentiment and valuations are at extremes (either positive or negative) the opportunity is for investors to take the other side; unfortunately, the pressure to join the crowd will likely prove irresistible.
   
   
9. Overcome terrible odds: Investors frequently make decisions where the odds of success are incredibly poor. We think that we will be the person to actually make money from a thematic fund or invest in a star fund manager who keeps producing astronomical returns. We just cannot help ignoring the base rates.
   
   
10. Find the ‘one’ investment: Although investors are aware of the benefits of diversification, it is a little boring and an admission of our own limitations. We would prefer to find the ‘one’ investment that will transform our financial fortunes, whether it be a stock, theme, fund or ‘currency’. Such ambition does not tend to end well. 
    

Throughout my career I have heard people say that ego and a level of arrogance are a pre-requisite for a successful investor because there is a requirement to ‘stand out from the crowd’. This is nonsense. These are dangerous traits, not beneficial ones. Far more valuable is being humble about the challenges of financial markets and aware of our circle of competence. We need to avoid being our own worst enemy.

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I have a book coming out! The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can find out more here.