Momentum investing: when is it time to get off the bandwagon?
The all-time highs we're currently seeing from the ASX are nothing short of a dream for momentum investors, who try to ride the market wave by buying stocks with strong historical performance.
But if you're investing for the long term, momentum investing may not be the way to go.
"To use momentum investing exclusively is great until it isn't," warns BlackRock fund manager Charlie Lanchester.
Rock bottom interest rates have shifted investment towards riskier assets such as equities, leading to stretched asset prices.
To be sure, momentum stocks can also be value stocks, broadly defined as those investors believe have solid future earnings potential. Lanchester points to Aussie healthcare as one example.
"Unlike many other Australian companies, they have maintained relatively low payout ratios and have instead reinvested increasing amounts into research and development which has enabled them to establish leading global positions in their respective markets."
"A differentiating benefit of being a conviction investor is that we can buy more of these businesses when these opportunities present themselves - the momentum investor does not have this luxury."
Investing on momentum alone is fraught with risk, since its success - or failure - is largely a function of behavioural biases. This works when everything's peaches and cream, but doesn't do so well when there's a run on the banks, as was the case with the global financial crisis.
When momentum investors are all chasing the same stocks and the market becomes crowded, opportunities can be overlooked. Moreover, just as buying the same stocks as everyone else works well in a bull market where prices are heading up, a market downturn can see these stocks lose the greatest value as investors race to the exit.
Lanchester says investors can also misunderstand the longevity of earnings among some of today's winners.
"Back in February 2000 the market was fuelled by momentum investing that collapsed as everyone ran for the exits and business models disintegrated."
As with most everything, you can have too much of a good thing.
"Momentum investing may be good over the short term but does suffer from sharp drawdowns as they rely heavily on timing the market. The conviction investor knows that in the longer term it is the good companies that will do better, so a portfolio of high conviction names may be more resilient and better positioned to rebound."
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