Few investment strategies have withstood the test of time, have been as extensively researched, or have been as profitable as momentum investing. In the book entitled Trend Following with Managed Futures: The Search for Crisis Alpha, the authors studied the price action of 84 equity, fixed income, commodity and currency markets as they developed between 1200 and 2013.

They went long (wanting prices to go up) and short (wanting prices to go down) based on prices being above or below their 12-month rolling returns. They found the strategy returned some 13 per cent annually. This was roughly 30 per cent better than the historical returns of buying and holding shares of large US companies, with approximately half the risk.

The strategy’s attractiveness revolves around its stellar risk-adjusted returns and the simplicity in its implementation. Momentum investing is a form of trend following, whereby the only variable involved in the decision-making process is the investment’s relative price change over a period of time or versus a reference basket. For example, if the price of gold is up more than other assets within a portfolio, over say a 6 or 12 month period, it should be bought.

Gary Antonacci‘s book entitled Dual Momentum Investing lays out a system of tracking the returns from an equally-weighted portfolio of just five exchange-traded funds representing the S&P500, US Treasury bonds, US investment grade corporate bonds, US real estate investment trusts and gold. His system simply subtracts the rolling 12-month returns of each product from the US T-Bill rate. If the rolling 12-month returns are positive he invests in the product; if not, he stays invested in cash. This simplistic approach to dynamic asset allocation would have since 1974 returned about 12 per cent a year, with an annualised volatility of just 6 per cent. Furthermore when measured on a monthly basis the maximum peak to through drawdown (loss) was just 10 per cent.

In a 2004 paper titled ‘The 52-week high and ,omentum investing’, T.J. George et al studied three approaches to momentum investing and found that all three systems resulted in generating excess returns. They found that investing in the best performing stocks that constituted the top 30 per cent of an industry group outperformed investing in the bottom 30 per cent of the same group by roughly 0.45 per cent per month. They also found that investing in stocks making new 52 week highs also outperformed by roughly 0.45 per cent per month.

Perhaps momentum investing’s success can be attributed to anomalies in our investing behavior. The herding mentality suggests we are influenced by the actions of others. As prices rally we buy, as others sell so do we. The ‘disposition effect’ suggests we sell too early and hold on to losers too long. So, for example, as prices go up we are early to get out, even though the stock hasn’t reached fair value, which could be much higher. Invariably others seeing the stock still trading below fair value will move the stock higher. Although in our digital age news travels quickly, due to conservatism bias we can react slowly to it. Also when good news has moved a stock close to a new 52-week high, we naturally fear buying at perceived high levels, even if favorable developments warrant it.

Clearly momentum investing offers investors a simple approach to creating excellent risk-adjusted returns which not only improves upon the buy-and-hold paradigm, but offers investors less volatility and lower potential for losses. Most momentum investing systems require minimal investor input, and portfolio re-balancing may be required only on the last day of each month.

To be sure, no investing approach is ‘bulletproof’ and patience and fortitude are required to withstand losing periods and the inevitable period of underperformance. However, based on the mountain of pervasive research which plainly demonstrates the efficacy of this approach, a disciplined and consistent execution plan should invariably return excellent results.

Joseph Portelli is the managing director and chief investment officer at FMG (Malta) Ltd.

Independent journalism costs money. Support Times of Malta for the price of a coffee.

Support Us