Momentum investing: A truly wild ride

What I learned as a momentum investor

Jeff Pierce, 35
Full-time trader and blogger at Zentrader.ca; Vancouver

When I first started trading around 11 years ago, I would look at price-earnings ratios and all the statistics. Positive earnings reports would come out and the stock would drop, or the reports would be bad and the stock would go up. And it just got me thinking ‘this is all garbage’—trying to analyze and determine what a stock is worth. You just have to follow the crowd. It took me two or three years to develop a strategy and I’ve been doing momentum swing trading since then.

I developed a system with my own indicators. I look at the markets, then the sectors, then the individual stocks. My two favourite indicators are the Relative Strength Index, or RSI, a technical measure that attempts to gauge if a stock is overvalued or undervalued, and the Average Directional Index, or ADX, which attempts to measure the strength of that trend. My system tells me when to be long, when to be short, and when to be in cash.

The best thing about using a system like this is that it helps you to overcome your bias about where the market is going. If you’re extremely bearish and think the market is going to fall, something in your brain will seek out information which confirms that belief. That’s why I don’t watch the news. I don’t read or watch anything to influence my opinion on what’s going to happen in the market. So far, everything is working out fine.

Investors who nimbly hop on a good trend often prosper. Sure the ride can be wild at times, but simply buying a portfolio of stocks that have seen big gains over the last year has been a winning strategy. It turns out that stocks that are going up tend to keep going up for a while, so jumping on a series of fast-rising stars and selling them off before they fall can lead to impressive returns over time.

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What is momentum investing? At its simplest, momentum investing means picking stocks based on how well they have fared over the past year compared to the average. The stocks that have risen the most are good positive momentum candidates. If that sounds suspiciously like technical analysis to you, you’re right. It is. Yet this approach has been working well for a very long time.

Famed investor James O’Shaughnessy examined the return pattern of portfolios containing the 50 best (and worst) performing large U.S. stocks each year in his book What Works on Wall Street. From 1951 to 2003, he found that the positive momentum group gained an average of 14.73% annually versus the market, which returned 11.71% per year. Stocks with negative momentum trailed with average gains of only 9.11% a year over the same period.

What time period should you use? You may be wondering if using a one-year time frame is special. Maybe buying based on a stock’s performance over the past six months or two years would be better? Indeed, these questions have inspired a host of research. The result? Some time periods do seem to be better than others for some investors.

One strategy is to buy a new momentum portfolio each month, hold it for a month, and then replace it. (It’s not quite day trading but it’s getting there.) And rather than measuring each stock’s momentum over the past year, you only look at the period ranging from 12 months to two months prior to the stock’s purchase date. In short, you ignore the performance during the past two months.

How do momentum stocks perform? Looking over the whole period from 1980 to 2010, the positive momentum portfolio has been a big winner. It provided average returns of 15.5% a year over 30 years. At the same time, the S&P 500 advanced 11.2%, meaning that the momentum strategy delivered a whopping 4.3 percentage point boost, on average, each year.

You should keep in mind, however, that these annual returns do not include fees, such as trading commissions, nor pricey frictions, such as bid-ask spreads. Given the frequent trading involved, those costs can really add up—in some cases to the point where this strategy could be unprofitable in practice. That’s why many traders are keen to opt for longer holding periods. For small investors, who face substantial trading frictions and commissions, rebalancing once a year is more practical due to the lower costs involved.

With this in mind, we’ve put together a list of 10 stocks that exhibit strong positive momentum. We’re opting for the less frantic O’Shaughnessy approach which means that you can hold the selected stocks for one year based on returns over the past year. Because his results are based on large stocks, we’ll stick to firms in the S&P 500. Our picks are shown in Top momentum stocks below.

What can go wrong? Momentum portfolios tend to be highly volatile and a small 10-stock portfolio will likely accentuate the already large swings.

If you’re keen on pursuing such a high volatility strategy, you’ll need an iron stomach and you might want to do it with only a small portion of your portfolio. One also needs a rather extraordinary level of faith that such a simple approach will continue to work, and you’ll be sorely tested in downturns. It can be very easy to give up on momentum at exactly the wrong time. Make no mistake, momentum isn’t for everyone.

Top momentum stocks

These 10 stocks had the largest price gain of all the stocks in the S&P 500 over the past year. Such stocks tend to keep surging for a while, so betting on the latest rising stars can pay off over time.