Serious Investors Hate This Simple Trading Strategy

Tech stocks made a feeble attempt at a bounce yesterday.

The Nasdaq Composite shot higher at the opening bell, only to lose its footing in the early afternoon. The tech-heavy index closed in the red for the third straight trading day.

Even a casual market watcher knows the high-flying tech leaders are overdue for a significant pullback. But now that we’re seeing some profit-taking, I have a feeling everyone’s going to start trashing momentum traders once again.

“Momentum works both ways,” they’ll say. “That’s what you get for chasing winners.”

Chasing winners. 

I hate that.

Likening momentum to chasing winning stocks makes the strategy sound so foolish. Only losers and simpletons chase stocks.

You hear this kind of talk all the time from all sorts of Very Serious Investors.

They’ll peer over their glasses and tell you that you can’t beat the market by chasing momentum.

The problem is most investors agree with this statement. After all, some guy in a suit and tie said it on TV. It must be true.

It’s not.

Momentum is the best performing strategy you can employ—yet barely anyone does it.

Most investors are too wrapped up in debating growth vs. value. Yet when it comes to performance, both growth and value trail momentum.

There’s data to back up that statement, too.

“Empirical data shows that momentum has indeed been a consistent long-term investment strategy,” John Hancock’s Frank Teixeira writes. “In fact, momentum factor returns have been stronger than those of either growth or value over the very long term, resulting in significant excess relative performance. Momentum averaged more than 3% in annual outperformance relative to the market from 1927 to 2014.”

Just look at all those growth and value funds.

Why is everyone pouring their hard-earned investing dollars into inferior strategies?

It’s because of their narrative filter.

It’s shockingly simple to force a growth or value strategy into your personal narrative.

Growth is the easiest sell. It’s all about stories. The next Facebook. The next Apple. Who doesn’t want to own these ideas? And value appeals to our more rational emotions. I want to make money safely using a rigorous, academic approach. Again, how could you say no to that? The stocks that eventually outperform are the hidden, undervalued, unloved gems. It makes perfect sense.

But momentum? Buying the strongest stocks on the market and then just repeating this process over and over? C’mon. That sounds ridiculous. The whole idea of momentum investing is too simple. And nothing simple could possibly work in the cutthroat world of the stock market.

Yet while momentum sounds simple enough, it’s not an easy strategy for most investors to use consistently. If you’re running any type of momentum strategy and rotating into the strongest stocks on the market at any given time, you’re buying a bunch of stocks most investors wouldn’t touch because at a glance, they look overextended.

Take a minute and think about the big momentum winners we’ve seen over the past 12 months. Facebook. Netflix. NVIDIA. Would you have forced yourself to buy these names as they surged higher?

Hindsight shows us that they all offered stellar returns after their strong initial moves. But in the moment, most investors would have skipped over these stocks or attempted to wait for a pullback that never materialized.

That’s why momentum ain’t as easy as it looks. But it works. If you can get out of your own way, you stand a fighting chance at grabbing the next round of massive momentum winners when the pullback is finished.

Sincerely,

Greg Guenthner
for The Daily Reckoning

The Daily Reckoning