Momentum investment strategy is determining positive relationship between a stock’s recent price history and its future price performance – known as the momentum effect – is one of the most heavily researched stock market anomalies. While the jury is still out regarding what causes the momentum effect, studies have shown that buying the stock market’s recent winners and selling its recent losses can be a rewarding (albeit volatile) investing strategy.
For this reason, many investors incorporate price momentum indicators into their stock selection process or hire investment managers to employ momentum-based strategies.
Stock market momentum is a great thing, but only when it is working in your favor. Below are three situations where momentum could throw a wrench in your investment performance.
When Investing In a Volatile Stock Market
If a smooth, trending stock market is a price momentum strategies best friend, a volatile market is its worst enemy.
Researchers have found that it suffered during periods of high stock market volatility. Other research has shown that momentum strategies perform better in rising markets than in falling markets.
Dr. Hancock came to the conclusions that, “Volatility is bad for momentum, largely because volatility is associated with mean reversion and not trending. And if one can predict volatility or a bear market, that no doubt has power predicting whether momentum will succeed. But the ability to make those calls with some precision about the timing is a skill that allows one to profit in simpler ways.”
Predicting when the stock market will become volatile or have a major directional change is very difficult. However, knowing when momentum strategies may suffer can help you better understand your investment performance. It can also help you identify investment managers that will complement a momentum strategy, like value-based investment managers.