`The latest in our Classroom series tackles the concept of momentum investing. The FAQ has been answered by Manish Dhawan of Mystic Wealth.
What is Momentum Investing?
Momentum investing is a strategy of buying financial assets (commodities, stocks, bonds, indices, derivatives) that are showing strength and selling those which are showing weakness. This strategy is based on the age old tenet of cutting your losses and letting your winners ride.
Gujarati traders have a simpler definition for this: “Bhav bhagwan che” (The price is Almighty).
Does it work?
Momentum as a factor in investing/trading has been studied extensively. There exist back tests dating as back as 200 years showing its efficacy and robustness across asset classes and geographies.
Elaborate studies have shown that on a trailing 12 month-period, assets that have outperformed peers tend to continue to give above average returns compared to assets that have under-performed during the same period, which continue to give below average returns.
Momentum chasing cannot be investing. It sounds more like gambling.
If you are a market participant, your end goal is to turn a profit.
The only way to do that is by following a strategy, which has an edge. So the only question you should be asking is whether your system has an edge.
Without edge, even value investing can seem like gambling. With edge, momentum is investing.
What do you mean when you say edge? How do you define and calculate it?
Edge is the ability of a strategy to generate above-market returns over a long period of time.
In fact, there was a time when the most prevalent view in investing was that it was impossible to beat the market, except by pure luck. This flowed from a theory called ‘Efficient Market Hypothesis’.
You can imagine the strength of the momentum investing strategy that Eugene Fama, father of the EMH, confessed that it had the best chance of beating the market. (But instead of defining this as edge, due to his philosophy that markets were efficient, Fama considered this an ‘anomaly’.)
Over the years, as back tests suggest, both value and momentum factors have generated above market returns to prove and substantiate their edge.
Have a look at Wes Gray's 100-year back test here.
Why don’t enough people follow momentum investing, if its edge is so evident?
Sugar is bad for us but don’t we love them? Simply put, we humans are subject to a lot of biases.
Here’s a question: how comfortable would you be buying a stock that has gone up 150% in last one year.
Your first thought would probably be that it has gone up too much. It takes a lot of nerve to buy something that’s already gone up a lot. That is why it’s not always easy to follow momentum investing.
The second reason is simply lack of awareness (at least in India). Everybody knows Warren Buffett. How many recognise William O’Neil?
Lastly, value investing has gained pre-eminence due to the following generated by (and sometimes marketing of) various fund managers and investors. According to some of such investors, chasing price is considered a sin.
To get a broader perspective on why not many people follow this approach read this blog post.
I am interested. Tell me more.
Momentum can be divided into two parts. Relative and Absolute.
Relative momentum: As the name suggests, it is an asset class' performance compared to its peers. (Amit scored better than Rahul)
Say gold rallied 12% in a year and equities rallied 10% during the same period. So we can say that relative momentum of gold is higher than equities.
Absolute momentum: Also known as Time series momentum, this is the asset class’ comparison with itself. For instance, ranking stocks on their 12-month performance (which would give you a list of stocks that have rallied the most).
Both these factors can be combined to form strategies. For ex. Gary Anntonacci wrote a research paper and a book on dual momentum where he combined both sub-factors to trade between a US index, emerging market index and bonds.
There can various iterations of this strategy: for instance, using absolute momentum to time your entry into a mutual fund.
Do you have more examples of people practising momentum investing successfully?
Plenty. But before that, we need to further segregate momentum into two fields: discretionary and mechanical.
Discretionary momentum is where individual traders decide the entry and exit points they think works for them.
It all started in the 1800s when an economist named David Ricardo amassed a fortune by the age of 40 by following a simple rule of holding on to winners and pruning the losers.
In the 1980s, many commodity traders generated outsized returns for a decade or more, following the discretionary strategy of riding the trend. The names include William Eckart, Ed Seykota, Dreyfus, the turtle traders, and Richard Dennis.
Currently, there are traders like William O’Neil, Mark Minervini, Jesse Stine and many more following the trend template.
In mechanical momentum, human intervention is removed completely and all exits and entries are pre-defined.
Some examples from the current lot of traders who follow this approach are Gary Anntonacci, Mebane Faber, Wesley Gray, AQR and many more.
How should I start off trading based on momentum?
Like anything, you start with the basics.
First, you define your asset allocation. Index, gold, commodity etc.
Then you decide if you wish to deploy a mechanical strategy or discretionary.
How can I decide that?
Well, nobody knows you better than you. The key to successful trading is to know who you are. Your strategy has to be in sync with your personality.
If you are a disciplined, unemotional, stoic individual, you can carve out a niche for yourself in discretionary trading. Though here’s a word of caution. Returns for successful traders would be superb, but the success rate is dismal. For every one successful discretionary trader out there, there are at least a thousand who failed at it.
Mechanical trading strategy is for those who are aware of their flaws and biases and are humble enough to admit that it’s impossible to overcome them.
While the returns would be satisfactory though not super, chances of success are a lot higher. And chances of a blow up are minimal.
Once you have figured that part of the puzzle, you get down to business. Create your strategies and back test it.
What do you mean create a strategy. How can I create a strategy?
Ok, so the idea is to buy what’s strong and hold it till it remains strong. There are various ways you can ascertain whether a stock is strong or not.
You can simply have a list of stocks that are trading at an all-time high, or a monthly high or a 52-week high.
You can rank all the stocks on their rate of change and stick to say, the top 30.
Then, once you have created a watchlist, the second part of the puzzle is to figure out an entry point and an exit point.
For sake of an example, here is a system
I create a watch list of all stocks trading less than 10% below their 52 week high. I buy any breakout on above average volumes and hold it till 10-week moving average price is not breached.
Ok. Any more advice on how to select a strategy from scratch?
But to summarise, stick to the below rules.
- Ride your winners
- Cut your losers
- Trade small (position size, diversify)
- Take every trade.
Sounds easy. Would it work?
A strategy can be something as simple as Mebane Fabers’ 10-month exponential moving average. He simply buys an asset class if it tops the 10-month EMA and closes the position when it breaches it on the downside. Guess what? It beats the standard ‘buy and hold’ strategy by a handsome margin.
Or the strategy could be as complex as calculating linear regression to remove sudden pop stocks (stocks that start trading higher suddenly after an event) from a momentum portfolio as described by Wesley Gray and AQR.
You have to get your hands dirty and backtest it yourself but remember, formulating a strategy is only 5% of the deal.
The remaining 95% is the ability to pull the trigger and stick to the strategy through thick and thin.
Will a strategy that has worked in the past work in the future? I have heard market disclaimers say past performance is no indicator of future results.
Momentum has worked for the last 200 years. The Lindy effect suggests that whatever has worked for a long time should continue to work in the future for at least a similar timeframe.
But are there any guarantees. No. Death and taxes are the only guarantees in life and that is why the disclaimer holds true. But broadly speaking, momentum investing should continue to work as they capture the basic human nature of greed and fear which are as old as the hills and are expected to remain an integral part of how humans think and more importantly act.
What could go wrong with my strategy and how will I decide whether my strategy itself is faulty or whether I should just persist with it?
That is a million-dollar question. In fact, I asked this question to Ralph Vince, who is considered a pioneer in the field of Risk management and system development. Here’s the podcast link.
He answered that parameters you defined at the time of back test are the only check at your disposal.
The attributes to judge a system include: Drawdown (both time and depth), Sharpe ratio, Average winners, Average losers, Win-loss ratio and R multiple.
If these parameters are intact and are behaving in accordance with your backtest, you are supposed to follow the system blindfolded, trusting it with your life.
Remember, at the time of a drawdown, the natural human tendency would be to discard the strategy, thinking it’s broken. The ability to pull the trigger at every buy signal is a hallmark of a great system trader.
How do I backtest my strategy?
First thing you need to backtest a strategy is data. You need to have closing price of the instrument you wish to test starting from as back as possible. More the better.
Then you have to decide the timeframe. Generally higher the timeframe, better the signal to noise ratio. For example, seeing the performance of Nifty 50 on a weekly timeframe would be a lot smoother than say an hourly chart.
The third thing you would need is to define your objective. No two people are same in that aspect. Is your objective to maximize your return no matter what or is it to get a reasonable return as long as you don't go under (drawdown) more than 30%?
The answer to that question would define your objective and in turn would decide your strategy parameters, your position sizing and the amount of risk you would be taking.
While simple strategies can be tested on an Excel file itself, more complex strategies require more robust backtesting methods such as walk forward and Monte Carlo simulations. For this, you would need a software. I use Amibroker.
How do I learn programming on that software?
Amibroker has an active library to get you on board. You can even buy a book written by Howard Bandy to get you started.
Please bear in mind, just like any other endeavour, this has its own learning curve.
Why does volatility matter when the end result is better?
That’s because not every investor has a high threshold for taking financial losses and a higher chance of a big loss could cause them to abandon their approach midway. For instance, small cap funds tend to do well but in 2008, they lost 70 percent of their capital. Investors fled.
The reason why drawdown is important for momentum investors is to ensure that their strategy is well within the pain threshold they can handle (also called the uncle point).
What exactly is a drawdown?
Drawdown is the erosion your equity curve has witnessed from its immediate high.
In other words, it is a peak-to-trough decline during a specific period for an investment, trading account, or fund.
Why is it important?
The return percentage by itself means nothing. Returns should always be adjusted for risk.
How do I know what is the right position size for my trade?
This is a whole new topic and will need to be tackled differently. But you can read a book by Van Tharp (Definitive Guide to Position Sizing), which is considered the bible on position sizing.
At a recent webinar, we discussed the same topic, detailing various position sizing techniques at the disposal of trader.
Ok. And how do I understand my pain threshold?
As a rule of thumb, whatever you think is your threshold, simply multiply it it by 0.7!
It is one thing to play with a tiger on your Playstation and totally another to face one in real life.
It also depends on the nature of money at your disposal. HOT MONEY is money you need to meet your expenses. Here you cannot tolerate even a 10-15% drawdown. Whereas cold money is money you do not need. Here you can even withstand 50% cuts.
Finally, it also depends on your personality. Do you track markets every hour or do you track it once in 3 months.
I am hooked. How should I improve my understanding of momentum investing?
There are some good books on momentum investing written by Andreas Clenow, William O’Neil, Mark Minervini, Gary Anntonacci and Wesley Gray. Try reading them.available here