Sunday, 31 January 2010

Be careful when playing momentum – the trend may appear to be your friend, but can quickly turn into a foe

Momentum – The trend is not always your friend

Posted by indianmutualfund

Have you ever thought why most stock tips you receive are about buying a stock that has done well recently, a recent winner? Are your brokers and friends great stock pickers who pick stocks that do well, or is it just momentum – picking stocks AFTER they have done well – at work? With no offense to anybody’s skills, it’s probably the latter.

Momentum is India’s favourite market strategy. Most stock picks and market recommendations, whether they come from a broker’s desk or a cocktail party, when looked at in any detail, point to momentum. What does that mean? Quite simply, it means betting on things that have done well recently – whether it is an individual stock, a particular sector or the market as a whole. A classic recent example – everyone wants to buy steel stocks because they have done well, everyone wants to sell telecom stocks because they have done badly. Buy winners, sell losers, it’s as simple as that.

Indians are not the only ones who understand or love momentum, and there is no magic behind it. Momentum is a time-tested globally known investment strategy with its roots in behavioural finance. When good news comes out, people under react because they are not sure, and the stock price doesn’t rise enough. The stock has room to go, and as more good news comes out, people overreact, driving the stock price up further. Similarly, on the downside, as bad news comes out, people over react to bad news, and in despair run for an exit, leading to a further correction. The tendency to overreact to bad news and under react to good news is timeless and inherent in human nature, and as long as it works, momentum trading will continue to work.

In fact, momentum has historically been even more powerful in India, than other global markets, and is one of the best performing strategies over the last 15 years. The most basic indicators have made for very favourable trading strategies. What makes it even more popular is that momentum is one of the easiest things to do – it takes very little to get the past prices of stocks and figure out which ones are doing well. You don’t need to know anything about the stock or the business to trade momentum – you could be following the price of bananas for all it matters.

Moreover, for a broker or an individual, momentum is a professional and socially safe strategy. You’re always following the trend, always selling what is doing well, and that’s a pretty easy sale to make. You always sound right, and who doesn’t like that? Compare this to value investing – after all the work involved in understanding a company’s inherent value and financials, you are the one rooting for an undervalued firm whose stock price has been beaten down. Even tougher, you’re running down a company that has done well because it is overvalued, even though everyone else loves it. It’s a pretty unpopular place to be in and a tough sale to make to a client.

Unfortunately, for all its ease and apparent money making abilities, momentum can revert pretty quickly, and when it does, it gets ugly. No trend sustains itself forever, definitely not in the short to medium term, and when a trend reverts, it is painful being a momentum trader. Think of 2007. For the three year bull run, markets were doing well, and every trader was bullish – momentum did well and every investor felt they had discovered a gold mine…until 2008 struck. The upward trend reverted, the market crashed and momentum crashed with it, and quickly. Momentum traders saw gains made over three years quickly erode as markets took a turn.

My favourite story about the dangers of playing momentum is Religare AGILE, a mutual fund that claimed to be a quant fund, but is actually just playing momentum. AGILE launched when the tide just turned and momentum was having its worse run. In a year when the markets were down 60%, AGILE bled much more. A period of downward momentum followed and AGILE did fine, but come May 2009, the downward trend reverted. The markets rallied nearly 90%, momentum strategies suffered, and AGILE returned less than 50%. AGILE’s poor performance, incidentally, has nothing to do with being a quant fund – many quants have done well over this period – it is simply playing momentum.

Cut to the last quarter of 2009 – another great period for momentum as the markets have had an upward trend, and to no surprise, AGILE has done superbly, as have other funds that have played the same trick. What will happen to them when the trend reverts, however, is the question?

Should you not play momentum or invest in a momentum fund? In general, yes, investing in a concentrated strategy is a bad idea – investments should be diversified across investment styles. If you do have to play momentum, do it in a conservative way with moderate risk. Most of all don’t be fooled by a manager’s great returns over a period – he may just be playing momentum. Check out his returns when the trend reverts.

Be careful when playing momentum – following the trend may appear to be your friend, but can quickly turn into a foe you had never bargained for.


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