Newton tells us that things in motion tend to stay in motion and things at rest tend to stay at rest.
This law appears to hold for the financial as well as the physical world.
In looking for different asset classes to combine to improve the returns of our portfolio, we’ve already discussed three of the four factors that contribute to returns in the stock market: the market factor, the value factor, and the size factor.
If the size and market factors are stories of increased risk leading to increased returns, and the value factor represents a mixture of increased risk and behavioral factors leading to increased returns, the momentum factor seems to be the story of pure human behavior.
I think of the momentum factor as an expression of the collective subconsciousness of all of the humans who interact with and thus influence the stock market.
Somewhere deep in our brains we humans seem to be hardwired to seek immediate gratification.
Our rational minds tell us that selling stocks that have recently performed well in order to buy stocks that have recently performed poorly is a good way to buy low and sell high. But if we are honest, we will admit that what we really want to do, deep down inside, is to double down on all the recent winners and get the hell away from the recent losers.
This is stupid. It’s the opposite of value investing.
But this weakness, present in all of our individual wiring, collectively, exerts a force on the stock market. Individually we have a hard time selling the over-performing stocks and so we have a tendency to delay doing so. On the other hand we want to rid ourselves of the dogs. So we sell quickly. And this tendency means that in aggregate stocks that are doing well recently have a tendency to continue doing well for a longer time than they otherwise would. And stocks that have underperformed recently will underperform for a bit longer than they otherwise would.
Our collective animal instinct to seek pleasure has its own inertia powered by our behavioral tendencies, which in turn has a measurable effect on stock prices.
Momentum: The human Factor
The momentum factor captures this inertia. What the strategy essentially entails is grouping stocks within an index based on their recent performance over the past year.
The better the recent returns of a stock, the higher the momentum score. The lower the recent returns of a stock, the lower the momentum score.
A momentum index includes more of the recent good performers and less of the recent poor performers.
Historically, momentum has been shown to have increased returns relative to the overall stock market, and even to the market, size, and value factors.
Some additional features to consider when thinking about investing in momentum:
1. Momentum indexes tend to require more trading, and therefore tend to have higher expense ratios when compared to purely capital weighted indexes.
2. Momentum tends to correlate with growth (the opposite of value) characteristics. As such it is an excellent diversifier for portfolios that have increased weight placed on value stocks. Better yet momentum ads to expected returns. Historically growth characteristics don’t.
3. Momentum tends to lag the market. So periods when the overall market is up will not necessarily be immediately reflected in momentum returns.
My overall take on momentum is that it’s a very attractive factor. It actually has the highest expected returns of all four factors including the market factor (beta.)
And I really like the idea of using a large cap momentum fund as a counter balance to a small value position.
On the other hand I’m a little hesitant to give up too much large-cap blend space in my portfolio, as this is probably the least expensive sector in the whole landscape of mutual funds.
And as I hope you agree, costs definitely matter.
