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Momentum Strategy – Yesterday’s Winners Are Tomorrow’s Winners

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The so-called momentum strategy relies on the stocks with the highest returns in the recent past. This naive trading concept achieved above-average profits in the past decades. Private investors can easily bet on the momentum factor with exchange-traded index funds (ETF). Stocks that have delivered the highest returns in the recent past tend to generate above-average returns in the near future. Conversely, yesterday’s losers are often also tomorrow’s losers.  It is also known as Relative Strength, because investors use this concept to select the companies that have historically generated the highest returns from a defined pool of stocks. Scientists usually speak of the momentum factor, the exploitation of which has led to high returns in the past decades.

Momentum Strategy: The Trading Concept

The momentum strategy is a quantitative trading concept in which the stocks held are regularly exchanged at relatively short intervals. There are numerous variations of this strategy. As a selection criterion, investors usually use the returns over the past six or twelve months. Based on this data, they create a ranking list of all stocks from the selected pool. Usually they buy the best 10, 20 or 30 percent. The worst 10, 20 or 30 percent, on the other hand, are sold short . With these so-called short positions, investors are betting on falling prices. They hold the often equally weighted winning and losing portfolios for up to twelve months. The composition of the portfolios is regularly adjusted on the basis of a current ranking after the selected holding period has expired.

Experts call it a market-neutral strategy to bet on rising prices with one group of stocks (long position) and simultaneously with another group on falling prices. Because theoretically, profits can always be made with this approach, regardless of whether the stock market is rising or falling. But, this only works as long as the long portfolio rises faster than the short portfolio falls when the market as a whole rises. Conversely, if the price falls, the shares in the short portfolio must fall more sharply than those in the long portfolio.

A momentum strategy with individual stocks is hardly feasible for private investors

By combining a long portfolio of winners and a short portfolio of losers , scientists and investors want to distill pure momentum returns from the market and eliminate other return drivers. But that is a rather complex undertaking. Since the long portfolio is primarily responsible for the return of a momentum strategy, investors and product providers often forego short positions in practice. For example, the momentum strategies of the index provider MSCI are long-only concepts that are replicated by exchange-traded index funds (ETF). For private investors, however, even such a stripped-down momentum strategy with individual stocks is hardly feasible. An international strategy that focuses on the largest developed market stocks would require you to regularly shift a portfolio of at least 160 stocks.

It is of course much easier and cheaper if you use ETFs on country markets instead of individual stocks . It is true that this dilutes the momentum factor. However, the costs of this variant are low and it can be traded for every private investor without great effort.

What’s the future like?

Despite the weak years, the balance sheet of the momentum strategy is impressive. But today’s issue for investors is whether this downright naive investing concept will work in the future as well? The solution is known to nobody. This is reinforced by the fact that in most local capital markets, the momentum effect has endured for decades and has been illustrated over numerous periods. The lack of a theoretical foundation speaks against the continued existence of this investment strategy. To date, there is no irrefutable explanation why a momentum strategy should yield an above-average return. The somewhat higher risk compared to the overall market does not sufficiently explain the sometimes exorbitant profits.

Hello, I have been working as an investment consultant and author for more than 20 years. I love what I do and I have enriched everyone around me. A lot of money is not important, the main thing is how you use the money.

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