Momentum: the most powerful factor

Today I want to talk about momentum. I’m always struck by the hand wringing I see from investors as prices reach new highs. This seems particularly evident over the last year during a great run for stocks. This is odd when you look at the historical evidence for momentum. Momentum is the most powerful factor in investing by a significant margin. Higher prices tend to lead to higher prices. Yet momentum is probably the hardest factor for most investors to internalize and implement in their portfolios. It is counter intuitive, especially if you have a heavy value bias as many do. In this post I want to highlight a very counterintuitive yet very effective strategy to emphasize just how powerful momentum can be and why momentum should be a part of your portfolio.

First, let’s remind ourselves of the evidence for momentum. Below is a table I’ve shown before. It is the AQR factor model (an enhancement to the famous Fama-French model).

Momentum (UMD in the table) is by far the most powerful of the factors. Almost twice as strong as the next strongest factor. Antonacci in his research on asset class momentum has some of the best and easily understandable evidence for it. Basically, you should consider applying momentum to your investing in some form or the other to increase your chances for market beating returns and lower risk. Now, let’s look at a very simple way to apply momentum to equities.

One of the most powerful expressions of momentum that I’ve seen is the Buy At the High strategy. Jake at Econompicdata describes the strategy at the bottom of this post. In this strategy you invest in stocks only if the previous month closed at a an all time high, otherwise invest in US treasuries. Sounds kind of crazy but look at the results.

Not only are the returns higher than buy and hold but more importantly drawdowns are reduced by a huge amount. High prices tend to lead to higher prices, until they don’t. This strategy would rank up there with the top TAA strategies that invest globally, don’t trade often, and beat buy and hold which I discussed in Choosing your first TAA strategy. It would also take you a few minutes a month to implement.

I ran this strategy through my database to get a better feel for the results. Since 1970, for US stocks (SPY), this strategy would have only had 5 down years with the worst year being a return of -6.7%. For global developed stocks, e.g VEA or EFA, this strategy would have had only 4 down years with the worst year being a return of -10%. In addition to the good returns and low drawdowns think about the emotional impact of these types of results. It definitely has a high ‘sleep at night’ factor. Yet, most investors would never consider this strategy. Something to think about.

In short, momentum is a powerful factor in investing but it is counterintuitive and thus hard for most investors to implement in their portfolios. A very simple TAA strategy, of owning equities only when they are making new all time highs, illustrates momentum’s effectiveness very clearly.