Momentum Investing – The Secret to Significant Portfolio Returns
Windowofworld.com – Two popular terms that often confuse investors are “trend-following” and “momentum investing.” Perhaps the most striking similarity between the two is their blatant defiance of “buy and hold,” the practice of choosing an investment and holding it indefinitely, believing that over time the market rises, and hence any investment will appreciate. Although the buy and hold approach has been touted for years by academics as the best investment method, in reality it has drawbacks, which are visible in every bear market.
Although it is the antithesis of buy and hold, both momentum investing and trend-following strategies are based on a disciplined investment approach designed to buy when the price of an issue rises and sell when the price falls. Moreover, exit strategies are usually combined to override the human tendency to hold a losing position for too long. But despite the different characteristics these two terms share, in reality they are very different.
What is Trending?
The following trend, in its most basic definition, is a systematic investment approach based on buying and selling of securities based on the ongoing price movements of the issue. It is important to note that trend followers do not predict future stock price movements; rather they examine the problem using technical analysis to determine which direction, if any, equities are currently moving. If a bullish trend occurs, trend followers will most likely buy positions in the stock and hold them until the trend starts to weaken or change direction. If equities show a downtrend, trend followers can short the position, wait for the trend to reverse, or just look for other problems.
But there is much more to being a successful trend follower than just picking and buying securities. In fact, it can be said that the most important aspect of following trends is not when and what to buy, but when and what to sell! Often times, successful trend followers set “sell rules” that must be broken before problems sell. These sell rules vary depending on the individual investor’s risk tolerance, but usually consist of a trailing stop loss combined with a confirmation indicator. The overarching benefit of the sell rule is that it provides a disciplined mechanical methodology that the average investor should seriously consider applying to his or her investment philosophy.
What is Momentum Investing?
Momentum investors are constantly looking for companies that are moving faster than the market. They believe that substantial returns can be realized if they find, buy, and sustain the problem as long as prices continue to rise. The old axiom, “if it ain’t broke, don’t fix it” illustrates the shared philosophy of momentum investors; firms with the largest price changes over the past few months are likely to continue to make substantial gains.
Fundamental analysis plays a much bigger role in investment momentum than in trend following. Momentum investors believe that being buried in a company’s income statement is the reason prices have risen so dramatically. And if the underlying reasons are revealed, opportunities present themselves to make use of that knowledge in the future.
In the case of trend following, investors want to identify where a security might be in the performance cycle. For example, how close is the current market price to a 52-week high or low and what is the direction of the short-term problem? For momentum investors, the key criterion may be the relative strength of the security versus the market or more importantly the peer group of the particular security in question.
How to Develop a Successful Investment Strategy
Investors often ask why they have to go through all the effort to actively manage a portfolio. The simple answer lies in the proven behavior of economic cycles and sector rotations. Independent studies have proven that over time the largest percentage of securities price appreciation is driven by the industry group in which the company is classified and not the performance of the individual companies themselves.
However, the real reason why investors should actively manage their portfolios is a concept called “Time Value of Money”, also known as “Compound Growth Rate.” Many financial professionals will use the example of how a penny, if doubled every day, is worth over $ 10 million in just 30 days. A very impressive and eye-opening figure considering the small amount of initial capital outlay. What would happen if instead of doubling the penny every day, it grew by only 75%? The investment will be worth a little over $ 195,000 rather than $ 10.7 million. Reduced the growth rate by 50% and its final value is now $ 1,917.51. A 25% growth rate over 30 days yielded a value of only $ 8.08.
How does the concept of multiple growth translate into investment strategy choices? Investors who actively manage their portfolios, either through trend following or momentum investing, have the ability to take modest profits and reinvest those gains in other trending securities over and over. Buy-and-hold investors do not get this luxury because they rarely sell when the price is above. Instead, they buy positions when the price is low, move up completely in a bullish market, and then see what losses are worth in a bear market. This is a very frustrating strategy, as hard on the stomach as it is on the wallet.
Both strategies, trend following and momentum investing, require a certain level of self-discipline to be successful. It is recommended to use a portfolio risk management system that uses the current market price and equity level of a position and some form of market volatility measurement. An example of such a system could be a proprietary market model that focuses on technical indicators, retested from time to time, supplemented by volatility indicators. This system may use the Average Directional Movement Index (ADX / R), the CBOE Volatility Index (VIX), or the more traditional Descent Line, Width, or Volume indicator.
Taking Portfolio Risk Management Systems One Step Further
One of the most popular management systems written by William O’Neil is CANSLIM. The CANSLIM approach combines fundamental and technical analysis such as the Core Equity Portfolio available at QMA Investment Management, LLC. The downside to the CANSLIM approach, along with many other similar systems, is that they stop providing systems that are truly beneficial to investors. The user ends up with a list of stocks, all of which meet the system’s criteria, but there is no method of distinguishing between the good, the better and the best.
To solve this problem, Alpha Advisor Service, LLC created an AAS Rating Score. This figure is the time-weighted risk-adjusted alpha value used to rank each of the 1,700 investments analyzed daily by the AAS. The purpose of the AAS Rating Score is to create a level field to measure all investment alternatives. Securities with the highest AAS rating provide the greatest risk-adjusted return compared to securities with the lowest rating. This approach is superior to other forms of alpha analysis because it is time-weighted, identifying stocks or funds that provide a greater return on the risk taken. A tool of this caliber, available to any investor via Alpha Advisory Service Bulletin, provides the means not only to develop a customized portfolio risk management system, but also a disciplined method for buying and selling securities in a portfolio.