Cursed By Momentum

Edgy Investors

Although most investors have no edge on the market there's a proportion of them that persist in trading actively, the main effect of which is to enrich their brokers. There are various explanations of why this occurs, but it seems to come down to some combination of inherent overconfidence and a perverse refusal to take account of negative information. 

This is particularly dangerous in calm periods such as those we’ve been experiencing in markets over the past few years.  In such times momentum strategies are particularly effective – and serve to supercharge the behavior of naturally overconfident individuals. The end results are usually not pretty..

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Google Charts You Can Trust

Exploit and Vanish

Although many investors rely on charts to time trades the actual evidence that this yields any kind of advantage is vanishingly small.  It’s not zero, however, as we saw in Technical Analysis on Display, because there’s a faint suggestion that human pattern recognition is so finely tuned that it may be able to extract information from the noise that machines cannot.

Intriguingly, though, research on Google search data suggests that there are exploitable trends in information signalled by interest in specific stocks.  Unfortunately merely publishing this fact almost certainly signals its demise as a useful prediction tool.  Exploit it while you can, because if you don’t, someone else will, probably using a supercomputer.

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Losing Momentum: Is It Time to Exploit Mean Reversion?

One Last Free Lunch

There are a range of so-called anomalies that have preoccupied investors for many years, largely because they seem to offer a free lunch, which is a rare thing in investment markets. So the momentum effect and various value-related effects have spawned a whole host of exciting but not entirely convincing ventures.

A range of recent research now threatens to actually shed some light onto these anomalies suggesting that the momentum effect has vanished and that value effects are real but caused by idiosyncratic factors. It also suggests that mean reversion, upon which many investing careers is based, generally works but sometimes only if you have an investing lifetime to wait. On a positive note, NOW might be a really good time to try and exploit it.

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Value in Mean Reversion?

Many shall be restored that are now fallen; and many shall fall that are now in honour (Horace, Ars Poetica)

From Horace to Graham and Doddsville

The quote above is now a couple of thousand years old but was used by Ben Graham and David Dodds in their seminal book on value investing, Security Analysis, a term invented by the book's title. At root it’s a simple plea for understanding that current market conditions, no matter how placid or tempestuous, will pass. The job of the conscientious investor is, at worst, to ignore the short-term forecasts or, at best, to take advantage of them.

Some psychological quirk means that a small subset of humanity latches onto this concept instantaneously and holds to it, like an investing life preserver, through thick and thin. The rest of us either learn the slow, hard and painful way or, more likely, continue to be storm-tossed. Occasionally someone gets washed up on a tropical paradise and is accounted a genius but mostly we drown, quietly, where no one can see us waving.

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Momentum Trading Madness

Jungle Survival Strategies

When we used to skulk about in the rainforest as undernourished and over-predated apes, evolution figured out that a good strategy for survival was to assume that any trend was likely to continue, once it had established momentum. Of course this occasionally went wrong when the volcano god got an attack of indigestion but generally tomorrow was likely to be pretty much the same as today, the antelopes were always at the waterhole at the same time and wandering into the sabre-toothed tiger’s lair was never a good idea.

Unfortunately to make money safely on the stockmarket you’ve got to assume exactly the opposite of momentum: that what worked yesterday won’t work tomorrow and that the tiger's never where you think it is. Which is not the way our ape-evolved minds prefer to work.

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