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Momentum: Exploiting Human Emotions

Momentum investing is all about avoiding extreme losses and profiting off the fear and greed of others

John Gabriel 26 October, 2012 | 6:00AM

Why does market momentum exist, and how can we exploit it?

While this is a very short and simple question, it has a relatively long and complex answer. In a nutshell, it ultimately boils down to investor psychology.

History has shown that investors are more apt to sell "winning" investments as they appreciate but hold on to "losing" investments as they fall. There is a sense of victory that comes with selling the "winners," and many investors like to think about what they will spend their profits on (for example, a new car, dream vacation, and so on). On the flip side, investors incur a great deal of pain with respect to their losing investments--so much so that the flight response is triggered and many investors even avoid looking at their account statements. Human emotions--namely greed and fear--take over.

Market momentum occurs because of behavioural finance issues. As long as there are passionate investors deploying capital, our biases as humans will prevail in the marketplace. We cannot deny it: psychology influences investors' decision-making and market movements. And some investors attempt to profit off of upward and downward market momentum which is caused by human psychology and biases.

At a recent Morningstar conference session in Chicago that covered momentum trends, panellists included Kevin Orr from F-Squared Investments, Mebane Faber from Cambria Investment Management and Brett Manning from Briefing.com. The panellists all agreed that investors must keep in mind that even when you encounter problems with momentum trend-following strategies, you will survive to fight another day. You will lose some money, but probably not all of your money.

Events over the past several years have proved that firms can and do go to zero at times (think Enron, Lehman, and so on). By their nature, a trend-following strategy would get you out of the market before the absolute bottom. That's not to say that there can't and won't be painful periods, but at least you should avoid the worst of the storm with a momentum-following strategy.

Avoiding losses is the key advantage of momentum strategies. Orr mentioned that, at his firm, they rely on momentum signals to "get out of harm's way" (that is, to go to cash, or move to the sidelines when the trend goes against them). Avoiding losses is so important to long-term wealth creation that Orr went as far as to note that their goal is to avoid loss, even at the expense of sacrificing upside.

Orr also noted that there tends to be a negative skew to the markets. Essentially, he said there is often forced selling that occurs in the marketplace, but forced buying doesn't really exist. Institutions may face redemptions or trigger margin calls that force massive selling pressure. Similar and indiscriminate pressures rarely exist when it comes to buying or making new investments. Moreover, general market psychology suggests that investors tend to focus on how they can capture as much of the upside market moves as possible by being invested in the market, as opposed to trying to get out of the way and avoid losses. To this point, Orr noted that zero (being in cash on the sidelines) is always better than a negative number (staying in the market when the trend goes against you). Again, building wealth is about avoiding the big drawdowns. Orr pointed out the simple arithmetic: A 50% loss requires a subsequent gain of 100% in order to get back to even.

Orr also mentioned that his firm believes that sectors are the "sweet spot" for momentum strategies. Furthermore, he offered some insight into how his firm's investment models utilise a dynamic approach to profit from momentum strategies. For example, his firm considers volatility trends to adjust the duration of the moving average figures they use for entry and exit points. If volatility is decreasing, risk could be rewarded, so the firm will extend the moving averages, thereby allowing them to stay in the market for longer. On the flip side, if volatility is increasing, they look to tighten up their moving average indicators, which will allow the investment model to react more quickly and get them out of the market earlier if the trend moves against them.

On the use of models, Orr noted that it is important to exercise discipline and have faith in your models. Keep in mind that a model should have a solid and intuitive basis. It's important to not try to outsmart or override what the model is telling you.

Faber added that models aren't these arbitrary tools. He reminded everyone that there are humans at the controls. Moreover, he noted that models can and do evolve over time. From time to time structural changes in the market do happen, and models should adjust accordingly. A good example is dividend-related strategies. Faber noted that, historically, looking solely at dividends might have been a good strategy. But more recently, corporate share buyback activity has increased significantly. Therefore, in a dividend strategy, it would be a mistake to focus only on dividends paid and ignore share buybacks.

The panel also discussed instances or market environments where momentum does not work. All the panellists agreed that the enemy of momentum is a trendless or "saw tooth" market. When there is no clear trend in a range-bound market, momentum and trend-following strategies will tend to underperform.

Trend-following strategies are the target of much criticism, particularly among fundamental and value investing circles that tend to have a longer-term horizon. In defence of momentum, the panel did note that trend-following and momentum strategies might be more common than a lot of us like to think. In particular, Faber pointed out that any market-capitalisation-weighted index will have a momentum component to it. That's because as a security increases in price, its weight in the index correspondingly increases.

Momentum strategies are certainly not for everyone. But no matter your investment approach, it’s still important to be aware of market momentum trends and the impact of investor psychology.

The original version of this article was a blog that was published by Morningstar.com in early October 2012.

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About Author

John Gabriel  is an ETF strategist with Morningstar, responsible for Canadian ETF research.