Monday, July 28, 2014

momentum investing

A massive academic study looking at the transaction data generated by individual investors over the past two decades basically shows that small traders tend to engage in trades that contribute to momentum returns. The same analysis if applied to the transaction data generated by large institutional investors shows that institutional investors tend to react more appropriately to gains and losses.

Essentially the individual traders are contributing to the returns generated from a momentum-based investment strategy. Basically, stocks that have the greatest ownership by individuals as opposed to institutions tend to show the strongest profits in response to momentum trading strategies.

Now, if it were the case that individuals contributed to momentum returns by behavioral biases, we would expect to see stocks with low volume - which would be more likely to be held by individuals - to exhibit stronger momentum returns. This is exactly what the data shows.

Basically, if you are going to buy momentum stocks, you want to buy those that are owned primarily by individuals as opposed to institutions. The straight-forward reason is that individuals are more governed by their psychology than institutions. As a result, individuals tend to become more risk averse when a stock rises in price and are likely to sell too early. This means that those stocks that have appreciated dramatically in price over the past months are poised to go even higher as they have been unduly sold by individuals who have become risk averse.

Additionally, there is good evidence that over the past seventy years, momentum strategies seem to work much better in periods of economic expansion. Generally speaking, momentum strategies do not work well during recessions and at the turning points when the economy shifts from an expansionary phase to a recessionary phase or vice versa.

If you take a step back and think about it, this makes logical sense. During an expansion, the stocks exhibiting the most momentum will be those which are benefiting the most from the expansion. These stocks will tend to be the most cyclical stocks, and those that will be hit the hardest if the expansion disappoints and the economy begins to contract. Keeping that in mind, if you are going to employ a pure momentum strategy, you must always keep one eye on the economy. If there is a whiff of a recession, you need to be transitioning to more of a value-driven strategy.

-- Mitch Zacks, ZIM Weekly Update     

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