Momentum investing can be risky

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Allen Wisniewski

Momentum investing is a style where you invest with the type of securities that have been doing well most recently. When the market is going in one direction, this strategy can oftentimes lead to large gains. However, in a market that lacks direction, this strategy can frequently backfire.

Many investors find a momentum style of investing quite appealing. All you have to do is look at the flow of assets into mutual funds, and you will see the strategy that has been working the best is attracting the most money.

This strategy also takes place in real estate. When the market is weak, it can be quite difficult to sell a house, even at a relatively low price. However, in a stronger market like we have now, that same house, with a price 20 percent higher, will attract many more buyers.

If you look at the stock market last year, the big winners were biotechnology, internet retailing and social media. Not surprisingly, these type of investments attracted much attention and new investors. What has occurred this year is that a number of these stocks have dropped around 20 percent from their recent highs, even though the overall market is near breakeven.

At the point of their recent highs, the biotechnology sector had increased 66 percent during the past 12 months, and internet retail was 89 percent higher during the same period. These may be fast growing companies, but their valuation reached a point where the stocks became quite expensive.

Looking at long-term data momentum investing does tend to work in the short run. A stock that does well in one month has a greater likelihood of doing better the next month versus an average company. However, during longer periods of time this strategy tends to lose its advantage.

Most individual investors who try to follow this strategy tend to get on board too late to reap much in the way of gains. However, they will tend to capture the losses when this style is no longer working.

Last year was not a typical year, as the stock market is generally not that strong.  Momentum investing works best when the stock market is going in one direction, with few setbacks. In a more sideways type of market, like we are seeing this year, a momentum style will not do as well, as the market is frequently reversing course.

There are some investors who like to do the opposite of momentum investing, and purchase out of favor stocks. That strategy has some merit, but one must be careful not to purchase companies that will be long-term under performers. For example, a stock may appear inexpensive because it dropped in price on an earnings disappointment; however, that same company may be weak for another year on continued poor results.

To be successful at momentum investing someone has to be a good trader.  Most individual investors are not skilled traders, so it is a strategy I would not recommend.  Also, in the stock market prices adjust to new information very quickly, so the likelihood of someone making large gains by following a trend is limited.

In real estate, where there is no exchange, prices adjust more slowly versus the stock market. Therefore, a momentum strategy would work better, as prices tend to move in one direction longer than they do for stocks. Nonetheless, even in real estate it would not be a good idea to overpay for a property.

With the sharp correction we have had this year, with many of the big winners from 2013, many people are fearful of a more meaningful sell off in the market. This reminds some investors of the period in early 2000 when the over-the-counter market was at an extreme valuation.

While some stocks have become somewhat pricey, valuations are not nearly as expensive as they were in late 1999 and early 2000. Therefore, I would tend to expect the stock market to stay in a trading range.

Momentum investing can be risky