Momentum Investing is a Tactical Asset Allocation using trend following and other systematic approaches, like seasonality and mean reversion, offering the potential for higher returns with less risk than buy-and-hold investing. Another benefit of a systematic, rules-based approach is that they can keep investors and asset managers from being swayed by thier emotions.
Most investors do not appreciate the advantages of universal trend following. They also do not react well when their portfolios are down 50% or more. As a result, they try to mitigate downside risk exposure through “strategic asset allocation”. This involves holding both stocks and bonds. It may also include minor allocations to assets like foreign stocks, commodities, managed futures, REITs, or cryptocurrencies. The 60% stocks and 40% bonds allocation is a popular example of strategic asset allocation.
The caveat with that is that most other asset classes have a smaller expected long-term return than US stocks. Investors using bonds and other alternatives sacrifice wealth for a minor reduction in portfolio volatility. Also, over the past 35 years, the correlation between stocks and bonds has been positive as much as it has been negative. Recently, the correlation has been more positive than ever. Positive correlation means less risk reduction through diversification. This can be especially problematic during crises. During times of market stress, all risky assets can decrease in value. Investors flee to safe harbors like Treasury bills and gold. This is one more reason to adopt a trend-following approach. Markets often show a loss of momentum before they drop sharply. The trend-based approach of Momentum Investing can then exit before much harm is done.
Investors often under-diversify by not using multiple approaches. Familiarity bias may also keep them focused on stocks and bonds. They may not realize, for example, that gold has outperformed the S&P 500 over the past 25 years. Central banks have been net buyers of gold for the past 15 years. This trend may persist as central banks continue to shift their reserves from the US dollar to gold. So it makes sense to apply systematic models to gold and boost its performance, since gold is such a good portfolio diversifier.
On the other hand, it is also possible to over-diversify by including assets or approaches that add little or no value. Our models omit small-cap, value stocks, commodity, managed futures, or inverse ETFs. These sometimes have short periods of outperformance. But even with trend filters, their inclusion would reduce our strategies’ long-term performance. The same is true with adding buy-and-hold assets.
“Over-diversification is for those who don’t know what they are doing.” Warran Buffet famously said. Our Strategies are designed to avoid under- or over-diversification.
