Momentum Magic…Past performance is really no guarantee

A recent article in The Economist elucidates the “Benefits of Momentum Investing”. Momentum Investing typically refers to the style of investing where the investor or the trader catches the momentum, both on the upside and the downside and then trades accordingly.

February 01, 2011 1:58 IST | India Infoline News Service

A recent article in The Economist elucidates the “Benefits of Momentum Investing”. Momentum Investing typically refers to the style of investing where the investor or the trader catches the momentum, both on the upside and the downside and then trades accordingly. The article says £1 invested in 1900 would have grown into £2.3 million by the end of 2009 by buying the 20 best performers over the past 12 months and then holding them re-balancing the portfolio every month.  If £1 had been invested in 1900 in the losing stocks it would have grown to a mere £49 over a century.

In such a long run we are all dead but we* tried to check if this momentum theory works to an extent in our Indian markets too.  To keep it simple, we took a 10-year horizon beginning with the Top 10 Nifty gainers and Top 10 Nifty losers of Year 2000. Let us assume that in 2001, a person invested Rs10 million in the Nifty gainers of the previous year. This is equally distributed among the top 10 gainers of the previous year.  Further, to check if negative momentum works, we put in a similar amount of Rs10 million in the 10 worst performers of the previous year. Having done this in two separate portfolios, we rebalanced both the portfolios on the 1st of January every year with the portfolio value at the end of the year. In other words, whatever the total value of our portfolio, we reinvested – the gaining portfolio amount in the next set of top 10 gaining stocks and the losing portfolio amount in the set of top 10 losing stocks.

The results are indeed interesting - 8 out of the 10 years if you invested in the gainers, you would have done better. In the calendar years 2002 and 2009 the strategy of investing in losers paid off well.

What an initial investment of Rs10 million gave at the end of each year…

Source: Bloomberg, India Infoline Research

The best performance for this strategy was calendar year 2006 when the top gainers outperformed the top losers by 150% and the best year for investing in losers was in 2009.

That’s not all. If you further analyze, even though 8 out of 10 times the gaining stocks outperformed, interestingly at the end of the 10 year period there is a startling fact. Would you believe that at the end of the 10-year period, the value of investment in the top ten losers stood at Rs93.8 million as against Rs68.7 million in the gainers?  

This of course can be explained by the events post 2007, which is known to all. By the end of 2007, the value of the gainers portfolio stood at Rs108 million as compared to Rs54.6 million for the losers. The devastation in the market in 2008 saw the portfolios more or less equal - Rs37.5 million and Rs35 million for the gainers and losers respectively. Then the tide changed in favour of the losers. Investing in the winning stocks in 2008 made the portfolio rise to Rs68.7 million in 2010 while investing in the top losers resulted in the portfolio rising significantly to Rs93.8 million.  All this was because the strategy of investing in the worst losers of 2008 gave the maximum benefit – the portfolio almost tripled with Rs35 million rising to Rs93 million in 2009. Meanwhile investing in the winning stocks in 2008 resulted in Rs37.5 million becoming Rs56 million in 2009.

If you calculate the portfolio gains before 31
st Dec 2007, clearly investing in the strategy of gainers would have done well. What it effectively means is that it takes just one catastrophic year like 2008 (when Lehman collapsed/Bear Sterns collapsed and the countless subprime events across the globe) for a dramatic reversal of fortune to happen. If the person with the winning stock strategy had exited the market in 2007 and even invested that money (Rs10 million had become Rs100 million by then) in simple fixed deposits, in calendar year 2010, he could happily retire and live like a Momentum Maharaj.

Unfortunately, all these things come only in hindsight. For many market momentum remains the pace at which you can suddenly start losing money.  So should we now invest in the winning stocks or losing stocks of last year? My advice to the investor is that years when the market has crashed dramatically like 2008, it is a better strategy to buy losers as they have “deep value” hidden in them and give better results on a bounce back. Losers can be winners, after all.  

* Aalok Shah and Anil Mascarenhas of IIFL contributed to this study.

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