Understanding Momentum

Understanding Momentum

Since its initial discovery by DeBondt & Thaler in 1985, the momentum effect has been documented and researched in many markets worldwide. Stocks which have outperformed in the recent past tend to continue to perform strongly over the months ahead.

Research conducted by Dr Bruce Vanstone and me indicates that Momentum significantly outperforms the major benchmark indices in both US and Australian markets. Investors, however, tend to focus on the annual rate of return without considering the accompanying volatility. Consider our simulation of Twiggs Momentum on the S&P 500 for the period January 1996 to June 2013 as an example.

S&P 500 TMO Equity Curve: click to enlarge

Dark green areas represent cash holdings, when market risk is identified as elevated. The blue line represents the benchmark S&P 500 index. Click on the image if you need a larger view.

Investment Strategy: Twiggs Momentum Buy & Hold
Starting Capital (USD): $100,000 $100,000
Ending Capital (USD): $4,871,686.27 $258,649.35
Annualized Gain: 24.89% 5.58%
Total Commission Paid (at 5 BPS): $66,194.35 $49.96
Number of Investments: 331 1
Win Rate: 54.38% 100.00%
Average Profit: 44.16% 158.79%
Average Loss: 10.15% 0.00%
Maximum Drawdown: 38.64% 56.77%
Maximum Drawdown Date: 9/11/2006 3/9/2009
Sharpe Ratio: 0.98 0.42

Investors tend to focus on the annualized gain of 24.89% p.a. without really applying their minds to the other statistics in the table. Maximum Drawdown of 38.64%, while lower than the index, means the portfolio is still subject to gut-wrenching volatility. Soaring gains are often followed by sharp falls and it takes strong resolve to stick with the strategy after one of these setbacks. Many investors would have abandoned ship after the first major drawdown in early 2000.

Another factor is the Win Rate of just above 54% which means that over 45% of all stocks purchased are sold at a loss. These are typical statistics for a momentum strategy, but investors can expect a high percentage of stocks to be cut from the portfolio for failing to adhere to the expected growth path. The strength of the strategy, however, is the expected gains on stocks that do adhere to the momentum growth path, with average profits exceeding average losses by a ratio of almost 4 to 1. That is where the excess returns are generated and is the reason why the strategy outperforms the benchmark index.

There are also extended periods where the portfolio remains in cash — long enough for doubts to grow as to whether momentum still works in the markets. My own view is that momentum strategies have been shown to outperform the Dow over the last 100 years and are likely to remain viable for as long as we have stock market cycles.

Coping with the emotional roller-coaster ride of investing in stocks is never easy, but here are some hints.

  • Focus on your investment time horizon of at least 5 years.
  • Check stock prices no more than once a week. Tracking prices daily or more frequently tends to cloud your judgement.
  • Welcome gains ahead of long-term averages, but expect them to fade over time.
  • If something unusual occurs, step back from the market, examine the long-term history, and ask: “Is this really unexpected or were my expectations unrealistic.”

That’s all for today. Take care.

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