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Momentum investing can make you money – too bad the downside is brutal

Shh! Don’t tell anyone, but in the dark corners where financial professionals congregate, momentum investing is many people’s quiet obsession. Playing the momentum game consists of nothing more than buying stocks that have gone up in recent months. After a while, you repeat the process, plucking a fresh crop of winners. Despite this simple—some might say, idiotically simple—approach, momentum strategies have produced standout results in the past few decades.

To be honest, this fact is infuriating. If you were brought up, as I was, on the gospel that smart investing consists of scouring balance sheets and looking for bargains, it’s tough not to see momentum investing as the Great Satan. Forget financial statements and close analysis and all that other hard work, momentum investors say. Just buy stuff that’s hot right now. This method sounds suspiciously like chasing performance, and so it is.

Yet momentum investing works when practised rigorously and systematically. In fact, it has beaten the market over 211 years of U.S. stock market history, from 1801 to 2012, according to AQR Capital Management, which is based in Greenwich, Connecticut. It has also performed well in 40 other countries and for more than a dozen types of assets other than stocks. Heck, some researchers have found that momentum even works when it comes to trading baseball cards.

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What nobody is absolutely clear on is why the strategy performs so splendidly. Maybe its extra return is compensation for extra risk. Maybe it reflects behavioural tendencies, such as how long it takes new information about a stock to seep through the market. But whatever. Even if you can’t explain how momentum performs its magic, its long record is tough to dispute. Big-name money managers such as Vanguard and iShares now offer exchange-traded funds that let ordinary investors play the momentum game.

Should you jump in? The answer most likely has more to do with you than with the strategy itself.

Consider what would have happened if you had invested $10,000 (all currency in U.S. dollars) in a large-cap U.S. momentum strategy in 1980. Your bankroll would have swelled to $816,472 by 2015, according to Charlie Bilello, director of research at Pension Partners LLC. By comparison, the $504,466 you would have achieved by sticking to the plain-Jane S&P 500 looks like chump change.

Here’s the catch, though. Your shortterm results would have lagged behind the market more than a third of the time, including an agonizing 30% underperformance versus the index from 2009 through 2012. If you had lost heart during one of these bad times, you would have stepped out of the strategy at precisely the wrong point, because momentum stocks then proceeded to stage a strong recovery.

My colleague Norm Rothery came to a similar conclusion when he examined a strategy of regularly buying the top 10 performers on the S&P/TSX 60 over the past 12 months. If you practised this approach, rebalancing your portfolio every month, you would have achieved an impressive 11.8% annual average return over the past 16 years. The problem? You would have lost nearly 64% of your money in 2009 and not fully recovered your losses until 2014.

Most people aren’t wired to accept such big swings. Imagine having to explain to your spouse that your genius investing strategy just wiped out two-thirds of your RRSP, and you begin to grasp the dangers of today’s momentum infatuation. Betting on hot stocks is just like most smart investing strategies—you earn your extra return by suffering through downturns.

There are other hazards too. Stock market researchers often discover factors that seem to be linked to strong performance, only to see those factors go into a long slump. Value investing, for instance, has been in a bad patch for the better part of a decade. Could momentum suffer a similar descent into darkness? It’s possible.

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One way to protect yourself is to use momentum as only one part of your overall strategy. Bet on momentum, but place an equal-sized bet on value. History shows the two approaches move in opposite directions: When momentum investors are celebrating, value investors are often crying, and vice versa. Using both strategies can help you navigate the inevitable bad spells for each.

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