"Buy low and sell high" might be the Holy Grail for most investors, but not everyone drinks that brand of Kool-Aid. For practitioners of momentum investing, it's more a matter of "buy high and sell higher."
In simple terms, momentum investing involves buying hot stocks or securities that have been increasing in value for three to 12 months in relation to their peers, then selling them when they begin to decline in value. The idea is that what goes up tends to keep climbing, and what drops will keep dropping.
Savvy investors would be wise to pay attention to how average Joes conduct themselves in the stock market. Empirical studies have shown that when a stock's value heats up, the masses pile on and drive the price up even more. When the stock cools, they hang on, hoping for a rebound so they can at least break even.
"Investors tend to be fairly predictable in regard to dealing with their emotions and how they buy and sell stocks," says Kim Inglis, Toronto-based investment adviser and portfolio manager for Canaccord Genuity Wealth Management. "Momentum [investing] really plays off that notion of behavioural finance."
Investors using the momentum approach buy before the price hits its historic high and sell just as the roller coaster begins to drop down the first hill. Think tingly stomach butterflies rather than chest-clutching terror.
It helps that markets aren't very efficient, says Gary Antonacci, author of Dual Momentum Investing: An Innovative Strategy for Higher Returns With Lower Risk and principal of Portfolio Management Consultants in Vancouver.
Inertia plays a role. When new information about an asset comes to light, it takes time before most investors catch on. "Initially, an asset will lag behind and then it will catch up and eventually overextend," Mr. Antonacci explains.
Momentum investors are always on the lookout for that lag. But it's not easy to find the sweet spot.
That's exactly what makes John DeGoey, a Toronto-based chartered investment manager with Burgeonvest Bick Securities Ltd. and author of The Professional Financial Advisor III, so wary.
"As long as things are going up, it's got upward momentum. But when it turns, it can turn quite quickly and that can be ugly," he says, citing the spectacularly abrupt fall of Nortel Networks Corp. between 2000 and 2002 as an example.
Many investors, both professional and retail, are reluctant to try momentum investing because it goes against the "buy and hold" advice that investors are usually given, says Dan Hallett, vice-president and principal of HighView Financial Group, in Oakville, Ont. Also unappealing are the increased trading commissions and tax implications that often come with constant rebalancing, buying and selling.
"It feels like a risky thing to be doing," Mr. Hallett says. "Like jumping off a speeding train and onto the next one. It's got the feel of a pretty aggressive strategy."
If investors' nerves are too jangled by the prospect, they can try what Mr. Antonacci calls "absolute momentum." Rather than focusing on specific stocks, investors jump in and out of the market itself. For example, if the S&P TSX comes out ahead of Canadian treasury bills, it's time to move into stocks. If T-bills gain traction, the investor sells the stocks and moves into bonds. Adhering to an absolute momentum strategy means avoiding large market swings.
"It won't get you out exactly at the top or get you in at the absolute bottom, but it will pick up most of that trend for you and keep you from getting beaten up when the markets go into severe drawdowns," Mr. Antonacci says.
Ms. Inglis hedges in a different way, diversifying by style of investing.
"If you take momentum style and value style and you weigh them 50/50, that combination actually ends up outperforming over the long run," she says. She uses the First Asset Morningstar Canada Momentum Index exchange-traded fund (WXM). The fund, which selects stocks that have momentum, outperformed the S&P TSX by 9.34 per cent last year.
While an ETF simplifies the process for the average retail investor, Ms. Inglis doesn't recommend trying momentum investing by picking single stocks. Buyers need plenty of time and know-how to understand exactly when to toss a hot potato without getting burned. The strategy also seems to work better with a large swath of assets, because of the volatility that often comes with individual stocks, she says. Diversification is important.
But Mr. DeGoey takes issue with momentum investing for the masses for another reason: too much market timing and speculating.
"If you buy high and sell higher, then the first question that begs to be asked is, 'Did you really buy high in the first place?' Maybe you bought fair," he says. "Maybe you bought low and sold high."