Investing with a momentum strategy was known to the public 20 years ago after a study published by Jegadeesh and Sheridam Titman, in which they “demonstrated” that the system was capable of returning 1% a month if they bought the best stocks of the last 3 to 12 months.
I just put the quotes (“) because it is not that clear that this is the best system to invest in the market, although I can say it is one of the best available, and it is not very complicated.
You do not need to be a NASA engineer to follow this system.
Actually, depending on anyone’s needs or criteria we can create thousands of different momentum systems.
You can choose among these variables:
- How many stocks will we choose for the system?
- What markets will we use?
- What period is best? 3 months, 4, 5, 6 weeks, 2 years?
- What period shall we keep our positions open?
- Will we use stop loss or not?
For instance, using the stop loss is not that typical in the world of investing, but it is quite used in the world of trading shorter time frames, specially times shorter than a year.
Although sometimes we do not know where the exact frontier between trading and investing is.
It will depend on every trader and investing goals.
Normally, we know that if we use stop losses our transaction costs will be increased, which in theory is bad for us.
However, experience also tells us that if your account is not huge using a stop loss can be of an advantage, especially when a big bear market occurs since those who do not use stop losses ride the whole of the bearish trend.
What these two economists discovered was nothing new under the sun, but a system as old as Wall Street, as Jesse Livermore would say in one of his most famous phrases when he explained that one of the best ways of speculating was buying the strongest assets, what he used to do most of the time, except when he failed his own discipline, moments when he would go bankrupt.
Another popular trader who used to use thy strategy was Richard Driehaus, who was famous by saying “you make more money by buying expensive and selling even more expensive”.
This might be true but it is not always the case.
As usual, the stock market is quite confusing.
Experience tells me that what Livermore or Driehaus said, besides Jegadeesh and Titman theory, is that this strategy is very good in big bull markets.
For example it was during 90s in most stock markets in the World.
Financial bubbles and momentum stocks
The fact is that during bubbles with very strong bull markets we usually can find some stocks that rise incredibly giving the chance to those who trade them to do some good returns.
One very good example of it is during the Nasdaq bubble during the 90s.
If you chose a strategy of buying the best stocks of the last 6 months during those years you would have probably beaten the market.
This probably occurred during Japan in the eighties or the United States during the roaring 20s.
The problem with this strategy is that when the bear market starts o the bubble explodes, they deliver very bad returns.
For instance, if we bought JDS Uniphase during the 90s because it was rising it would have been a great investment or trade, however if we kept this stock later it would have been a disaster.
When the financial bubble comes to an end it is better to have companies that pay good dividends.
In trading and investing everything has to be seen with perspective.
There is never a better strategy than other for all the time and markets, especially when the strategies are “simple”.
Eventually different strategies will level themselves in the long-run.
Momentum strategies will win in periods like 1982 to 1999 and lose in periods like 2000 to 2010.
A lot of people think that what Buffett did with his “value” ideas is somewhat easy, but nothing farther from the truth.
“Value strategies” are quite subjective and will depend on everyone’s instinct, and not everybody has Buffett one.
Having said that, buying stocks with good prospects and at a “good price” is a strategy that will probably give us acceptable results in the long run although do not think you will make an average of 18/20% return a year like the Oracle of Omaha.
Regarding stop loss orders I would like to say something.
If you want to use a momentum strategy you should use stop loss orders and not be scared to do so.
It is true that sometimes they will take us out of some small corrections but they will make sure that we do not suffer great bear markets so badly.
In this sense, it is good remembering great momentum strategies like that of Nicolas Darvas, when he explained how he traded stocks.
The tactics to buy the momentum stocks and sell them are many, as many as the imagination of the trader allow.
The most important thing is: cut losses and let profits run.