π Riding the Wave: Mastering Stock Investing Momentum for Big Gains - A Masterclass from Alejandro Yela
The Hermit: Demystifying investing in small companies and discussing experiences lived during a decade as an investment professional
Hello friends π
Iβm the author of π§ββοΈ The Hermit π§ββοΈ and I made $1,180,882 investing in stocks in 2023.
π§ββοΈ The Hermit focuses on demystifying investing in small companies and discussing experiences lived during a decade as an investment professional.
If you enjoy this post, I suggest you check out the following:
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What is Momentum?
Let's start by defining the momentum factor, which could be considered the inertia of the market. The prices of a financial asset tend to positively correlate with its most recent trajectory.
βοΈ A famous study by the London Business School selected and bought 20% of the best-performing stocks in the previous 12 months and shorted the worst 20%.
Over 52 years, the annualized return of stocks that had outperformed the market in the previous 12 months was 18.3%, while the worst performers rose 6.8% on average. During that same period, the market as a whole grew 13.5% annually.
π In a later study (using data from 2000 to 2007) the momentum effect was proven as a key factor for price fluctuations in 16 additional international markets.
With this in mind, sometimes momentum works, and sometimes it doesnβt.
Momentum Today
π In 2024, the momentum factor seems to dominate the markets. We see its tangible effect via the performance of the giant American technology companies.
Some experts estimate that we are in the strongest momentum market in the last 25 years.
That said, this phenomenon has no connection with company fundamentals. Instead itβs explained by the emotionality of the investor and changes in behavior involving elements like herding or mismatching probabilities.
π Herding is a behavior where investors tend to follow the actions of the majority rather than making independent decisions based on their analysis.
E.g. The Post-COVID Recovery
π The stock market's recovery after the initial COVID-19 pandemic shock in 2020 is an instance where momentum played a crucial role.
Stocks like Zoom, Tesla, and Amazon saw rapid increases in their stock prices as the market rebounded. Momentum investors who bought into these stocks early in the recovery phase benefited from substantial gains as these stocks continued to perform well.
For example, Tesla's stock price increased by over 700% from the beginning of 2020 to the end of the year, providing substantial returns for momentum investors.
Cognitive Biases
π Two cognitive biases are responsible for the momentum factor:
1.Β Β Β Availability
2.Β Β Β Regret
βοΈ First, there is availability bias, which is the tendency we humans have to remember recent events more vividly and give them undue importance.
π π₯ We are most likely to get fire insurance after experiencing a fire.
This way, if the price of an asset increases over time, investors can extrapolate this price increase and assume that it will continue to occur in the future (and sometimes forever).
Research indicates that this trend is more pronounced among retail investors since many professional investors expect a reversion to the mean. This would explain why hedge funds have been selling technology in recent sessions.
π€·ββοΈ The other factor that affects us is the regret bias, which is the feeling that surfaces when we believe that we have missed an opportunity commonly known as Fear Of Missing Out (FOMO).
Faced with regret for not owning a stock that is performing magnificently, the investor may feel emotionally driven to remedy it by purchasing the share, which provides additional fuel for the upward movement to persist.
E.g. The Technology Sector Boom
π¨βπ» During the late 1990s, the technology sector experienced a significant boom. Companies like Microsoft, Cisco, and Intel saw their stock prices skyrocket.
Momentum investors who identified the rising trend early were able to ride the wave of increasing prices. For instance, an investor who bought shares of Microsoft in 1995 for $5-6 and held until 1999 (the peak) would have 10x their investment.
The momentum factor drove prices higher as more investors jumped on the bandwagon, pushing prices even further.
Momentum on the Downside
π’ Of course, the hasty abandonment of the momentum factor by investors constitutes one of the most terrifying experiences we can have in the financial markets.
These turns are usually preceded by radical changes in market narratives and extraordinary events.
E.g. The 2008 Financial Crisis
π The 2008 financial crisis provides an example of the downside of momentum investing.
Leading up to the crisis, financial stocks were performing well, and momentum investors continued to buy into them. However, when the market turned, these same stocks plummeted.
π¦ Lehman Brothers, for instance, went from being a leading investment bank to filing for bankruptcy. Momentum investors who didn't exit their positions in time faced significant losses.
π€ Will you take momentum into account when making your next investment decisions?
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