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Momentum Investing – Greater Fool Theory On Steroids

By: Frank Armstrong

By: Frank Armstrong, CFP, AIF

Although momentum investing can be unusually successful for several months, or even a couple of years, it has proven to be a low return, high risk strategy for the long haul.

Momentum investors buy stocks that have gone up in price. The most often quoted rationale is that the market has not yet properly priced positive “earnings surprises”. As the theory goes, a company that has had one earnings surprise is more than likely to have more. So stocks that have appreciated will appreciate more. Price momentum signals further price increases and is presumed to persist.

In practice, this often looks more like a greater fool theory on steroids. When a large number of investors chase a few growth stocks, they can drive the price of the stocks up. Other investors, seeing the stock’s price rising, jump on board. Of course, this sets off another round of price increases, which in turn attracts new investor interest. It doesn’t take long before the prices leave the realm of economic reality, but each rise in the price level confirms the wisdom of the previous purchases.

As the prices head for the stratosphere a weird mindset emerges in which the participants convince themselves that “this time it’s different” and proceed to redefine risk as not owning the stocks regardless of the price.

For a short while, the results look great. But this strategy sows the seeds of its own collapse. Sooner or later prices get so far out of bounds that any little thing can cause a tumble in price as investors none too gracefully all head for the door at once. Folks, its not a pretty sight.

Momentum investing seems to be exclusively a growth stock phenomenon. Typically the stocks are high P/E, high turnover, and high price appreciation over the trailing period. To play the game successfully, investors must both jump on the trend early, and then time their exit before the other players wise up. The second part is particularly difficult for the players due to the tendency of all concerned to extend past performance into the indefinite future.

A consistent momentum stock investor must expect sub optimum performance throughout a typical market cycle (i.e. low returns and high risk). But, the almost irresistible tendency of many investors to select mutual funds based on past performance traps many who join the party just before the predictable final plunge begins. These unfortunate wretches suffer greatly.

Many fund investors cannot help themselves. For lack of any rational investment plan, they blindly invest in last year’s winners. Of course, when the bubble inevitably bursts, those same investors start looking around for another fund with great short-term performance. The all too predictable result: a downward spiral and failure to attain any reasonable performance.