When a behavior leads to a positive outcome we are more likely to repeat that behavior, a phenomenon known in psychology as ‘positive reinforcement.’ Momentum trading fits this description rather well: if your winners keep winning, it’s probably a good idea to keep investing in them. In this episode of ‘What’s Your Prior?’, Damian Handzy explores the momentum strategy with renowned Trend Follower Dr. Kathryn Kaminski, co-author of the book on the topic called Trend Following with Managed Futures and Chief Research Strategist and Co-Portfolio Manager at hedge fund AlphaSimplex. We dive into how Momentum traders think about markets and when this strategy works the best.
Momentum traders or ‘trend followers’ make money violating the most common advice lawyers require every investor to receive: previous performance is not indicative of future returns. They take advantage of the idea that what did well yesterday will probably do well today and tomorrow; but such trading, en masse, can lead to price bubbles. Damian had someone describe momentum as a ‘lemming strategy’, just follow the winners. You don’t have to think about whether companies are overpriced and you don’t need to assess if they’re a bargain or if they’re in the right industry. According to Katy, this is correct as she explains, ‘understanding what’s causing the trends is not part of the analysis’, further suggesting that perhaps that’s why many investors were initially skeptical about this approach to trading because the general consensus is that it’s better to have a view about the economy. Many investors value the detailed assessments of company financials, management priorities, industry trends, and so on, but Katy counters this with the question; ‘at what point do these fundamental values actually incorporate themselves into the market?’ At the end of the day, Momentum traders point out that prices incorporate a LOT of information and using that one number’s trend can eliminate a lot of noise.
In a sense, momentum trading is different from most strategies because it is unemotional and detached: momentum traders don’t allow their beliefs about the market to interfere with how they trade because they don’t trade based on those beliefs. They don’t ask why something is priced either high or low, they just want to know what worked. This is the part some investors find tricky, the idea that one should follow a trend without even attempting to understand it is not only difficult but almost counter-intuitive in the world of investing. Momentum trading speaks to the Bayesian approach, letting reality be the basis of your beliefs rather than trying to get reality to bend to your preexisting beliefs, something Katy and Damian discuss in further detail on the podcast.
However, trend following can lead to price bubbles and overvalued assets. Damian posed the following question to Katy; as a momentum trader, if the trend keeps going up, will you keep contributing to the bubble, if we’re in a bubble? Find out what she had to say by checking out the full conversation covering bubbles, trend spotting and tracking, when trend following doesn’t work and more.
Listen to the full podcast episode here!