|
Home / Finance / Investing
Momentum Investing and Trend Following: The Secret to Significant Portfolio Returns
By:Justin Lenarcic
Two popular terms which often confuse investors are "trend following" and "momentum investing." Perhaps the most glaring commonality between these two is their blatant defiance of "buy and hold," the practice of selecting an investment and holding it indefinitely, believing that over time the market goes up, and therefore any investment will appreciate. Although the buy and hold approach has been touted for years by academics as the best method of investing, in reality it has its shortcomings, which are apparent in every Bear market.
Despite being the antithesis of buy and hold, both momentum investing and trend following strategies are predicated upon a disciplined investment approach that's designed to buy when the price of an issue is increasing and sell when the price is declining. Additionally, an exit strategy is normally incorporated to override the human tendency to hold losing positions much too long. Yet despite the distinct characteristics that these two terms share, in reality they are quite different.
What is Trend Following?
Trend following, in its most basic definition, is a systematic investment approach predicated upon buying and selling securities based on the sustained price movement of the issue. It's important to point out that trend followers don't predict the future price movement of a stock; rather they examine the issue using technical analysis to determine which direction, if any, the equity is currently moving. If a bullish trend is emerging, the trend follower will likely buy a position in the stock and hold it until the trend begins to weaken or change direction. If the equity exhibits a bearish trend, the trend follower can short the position, wait until the trend reverses, or merely find another issue.
But there's much more to being a successful trend follower than just selecting and buying securities. In fact, it can be argued that the most important aspect of trend following isn't when and what to buy, but rather when and what to sell! Often times, successful trend followers establish a "sell rule" that must be violated prior to selling the issue. These sell rules vary depending on the risk tolerance of each investor, but they typically consist of a trailing stop loss coupled with a confirming indicator. The overarching benefit of sell rules is that they provide a disciplined, mechanical methodology which the average investor should seriously consider implementing into his investment philosophy.
What is Momentum Investing?
Momentum investors are constantly searching for companies that are moving faster than the market. They believe substantial returns can be realized if they find, buy and hold onto those issues for as long as the price continues to go up. The old axiom, "if it isn't broken, don't fix it" illustrates the shared philosophy of momentum investors; those companies with the biggest price changes over the last few months are more likely to continue making substantial gains.
Fundamental analysis plays a much bigger role in momentum investing than it does in trend following. Momentum investors believe that buried within a company's earnings statement is the reason why the price has been increasing so dramatically. And if that underlying reason is uncovered, the opportunity presents itself to capitalize on that knowledge in the future.
In the case of trend following, investors want to identify where a security may be within the performance cycle. For example, how close to the 52-week high or low is the current market price and what is the short-term direction of the issue? For the momentum investor, the key criteria may be the relative strength of the security versus the market or more importantly the peer group of the particular security in question.
How to Develop a Successful Investment Strategy
Investors often ask why go through all the effort of actively managing a portfolio. The simple answer lies in the proven behaviors of economic cycles and sector rotation. Independent studies have proven that over time the largest percentage of a securities' price appreciation is driven by the industrial group within which the company is classified and not the performance of the individual company itself.
However, the real reason why investors should actively manage their portfolios is a concept called the "Time Value of Money," also known as "Compounding Rate of Growth." Many financial professionals will use the example of how a penny, if doubled every day, is worth over $10 million after only 30 days. A very impressive and eye opening number given the small amount of initial capital outlay. What would happen if instead of doubling the penny every day, it were to grow by only 75%? The investment would be worth slightly over $195,000 rather than $10.7 million. Reducing the growth rate further to 50% and the end value is now $1,917.51. A 25% growth rate for 30 days produces a value of only $8.08.
How does the concept of compounding growth translate into the selection of an investment strategy? Investors who actively manage their portfolios, either through trend following or momentum investing, have the ability to take modest gains and re-invest the profit in other trending securities over and over again. Buy and hold investors are not awarded this luxury since they rarely sell when the price is at the top. Rather, they buy a position when the price is low, ride the position all the way up in a bull market, and then watch as is loses value in a bear market. It's a very frustrating strategy, equally hard on the stomach as it is on the wallet.
Both strategies, trend following and momentum investing, demand a certain level of self-discipline in order to be successful. A portfolio risk-management system that uses the current market price and equity level of a position and some form of market volatility measurement is recommended. An example of such a system could be a proprietary market model focused on technical indicators, back tested over time, coupled with a volatility indicator. The system might employ either the Average Directional Movement Index (ADX/R), the CBOE Volatility Index (VIX) or the more traditional Advance Decline Line, Breadth or Volume indicators.
Taking Portfolio Risk Management Systems One Step Further
One noted management system authored by William O'Neil is CANSLIM. The CANSLIM approach combines both fundamental and technical analysis much like the Core Equity Portfolio available at QMA Investment Management, LLC. The weakness in the CANSLIM approach, along with many other similar systems, is that they stop short of providing a truly utilitarian system for the investor. The user ends up with a list of stocks, all of whom have meet the systems criteria, but no method for distinguishing between the good, the better and the best.
To address this problem, Alpha Advisor Service, LLC created the AAS Rating Score. This number is a time-weighted risk-adjusted alpha value used to rank each of the 1700 investments analyzed daily by AAS. The purpose of the AAS Rating Score is to create a level field to measure all investment alternatives. The highest AAS rated securities provide the greatest risk-adjusted return compared to the lowest rated securities. This approach is superior to other forms of alpha analysis since it is time-weighted, thereby identifying those stocks or funds that are providing greater returns for the risk taken. A tool of this caliber, which is available for any investor via the Alpha Advisor Service Newsletter, provides the means of not only developing a customized portfolio risk-management system, but also a disciplined method of buying and selling the securities within the portfolio.
Digg
del.icio.us
Blink
Stumble
Spurl
Reddit
Netscape
Furl
Article keywords: Momentum, Investing, Trend, Portfolio, Stocks, Mutual Funds, ETF, Portable, Alpha
Article Source: http://www.articles2k.com
I provide a twice-weekly newsletter designed for investors seeking to build and manage investment portfolios. We analyze over 1700 securities including stock, ETF, and mutual fund investments as well as provide "Buy Recommendations" and "Sell-Limit Watches." Try our 30-Day FREE Trial and see how powerful our analysis is!
|
|
| Top Investing Articles |
- 1). Day Trading With The Camarilla Equation By : Steve Waller
Origins of the Camarilla Equation
Discovered while day trading in 1989 by Nick Stott, a successful bond trader in the financial markets, the 'Camarilla' equation uses a truism of nature to define market action - namely that most time series have a tendency to revert to the mean.
The equation produces 8 levels that are meant to predict these reversal points allowing the trader to profit from them.
|
- 2). HYIP’s versus Autosurfs: Which Is Better For You? By : Hyip-Status.com
A high yield investment program is essentially an investment in which you have the choice of how much you can invest in the program, hoping for a high yield. Any amount can be invested in a HYIP, and in fact small amounts works rather well for HYIP’s, but there is an advantage (and disadvantage) to using large investments.
An autosurf is better known as a “traffic exchange”; a person buys advertising that is placed in rotation with other advertisements.
|
- 3). How to Interpret and Profit from Financial Statements By : Pleeds
Financial statements are a useful tool for judging the health of a company, and for comparing it to its competitors. They show what the company owes and owns, the profits or loses it has made over a given period, and how their position has changed since their last statement. Generally if you can tell which direction a company is heading in, you can also forecast future stock prices with some accuracy.
|
- 4). Taking Control of your Finances. By : Debra Lohrere
To find money to invest for your future, you need to make sure that your outgoing expenses are less than the income that you are receiving. You need to develop an excess that you can have free to invest.
Now before you start to think….”well I don’t have any excess left…if I was earning more money….then I would have some free”. Let me dispel this myth…and tell you that it is a known and excepted fact that the amount of money that people earn has little if any bearing on whether or not they have an excess left to invest.
|
- 5). High Yield Investing Is Like A Game Of Poker By :
We often get newbies emailing us asking whether or not investing in HYIP's is worth the time and the risk. This is a great question and the short answer is "it all depends".
First of all, the main question you must ask yourself before investing in any HYIP is: "Do you plan on investing money that you will definitely need in the future?" In other words,.
|
|
|
- 7). Different Kinds Of Investments By : Juan José
These days, you can’t retire without using the returns from investments. You can’t count on your social security checks to cover your expenses when you retire. It’s barely enough for people who are receiving it now to have food, shelter and utilities. That doesn’t account for any care you may need or in the even that you need to take advantage of such funds much earlier in life.
|
- 8). A Cooling Real Estate Market and Investing in Pre-foreclosures By : John Appleseed
With the housing market cooling and demand for mortgage loans shrinking, banks and other lenders are turning to nontraditional and sometimes riskier mortgages to bring in additional business and make up their dropped off business.
Many lenders have turned to mortgage products designed to lower monthly loan payments and to help borrowers qualify more readily for larger loan amounts, while others require little in the way of documentation during the approval process.
|
- 9). FOREX Investing Compared to Other Investment Opportunities By : Cindy Brooks
With over $1.5 trillion changing hands daily, it might be advantageous for you to investigate the extremely lucrative business opportunity involving currency trading.
Once the domain of major banks and corporations, this field is now an open playground for the ordinary individual.
The following information gives you a comparison of different investment opportunities in comparison to Forex trading Forex could be the perfect opportunity for you if you are willing to have an open mind and investigate.
|
|
|
| New Investing Articles |
|
|
|
|
- 3). What Is An Investment Club? By : Roy Phay
Investment clubs are very hot in the market nowadays. Thousands of individuals are investing through clubs, and many of them find a great deal of success.
|
|
|
|
|
- 6). Investing in St. Louis Real Estate By : Robert Palmer
It is common for investors to express uncertainty over their ability to manage their portfolios during prolonged periods of market volatility. But prudent investors understand that making sound investment decisions shouldn’t be based on the market’s twists and turns. Rather, these decisions should stem from an understanding of investment fundamentals and an awareness of the mistakes others have made.
|
- 7). How Investment Options Works The For Buyer By : Ian Dennis
A call investment option is a financial contract involving two parties, the buyer and the seller of this type of investment option. Often it is simply labeled a "call". The buyer of the option has the right but not the obligation to buy an settled quantity of a particular commodity or financial instrument from the seller of the option at a certain time for a certain price.
|
- 8). The Dow Jones Industrial Average: Failing the Average Investor By : Steve Selengut
In addition to a well thought out Investment Plan, successful Equity investing requires a feel for what is going on in the real world that we all refer to as "The Market". To most investors, the DJIA provides all of the information they think they need, and they worship it mindlessly, thinking that this time tattered average has mystical predictive and analytic powers far beyond the scope of any other market number.
|
- 9). How to Spot Market Turning Points Using Free Legal Insider Information By : Steve Todd
How would you like to be able to take advantage of insider information and trade with the most successful traders in energies commodities, stocks and commodities?
Well you can - with the commitment of traders report, published by the CFTC. This report shows insider commercial trading positions by professional hedgers!
The commitment of traders report is available FREE, but hardly any traders use it - yet it can predict tops and bottoms, with amazing accuracy, when used correctly.
|
- 10). Market Timing – A Danger to Your Financial Success By : Steve Todd
Market timing are the two most dangerous words in investing - especially when practiced by novice traders.
Market timing is the strategy of attempting to predict future price movements through use of various fundamental and technical analysis tools - and when used to predict trending moves, ends in disaster, and losses.
Many investors feel that market timing is the same as trend following and the two go hand in hand, they don’t.
|
|
|
