I am an investing nerd. I read white papers like other people read gossip magazines. I don’t follow athletes or celebrities on twitter or anywhere else, but there are about 25-30 money managers, economists, and other people in the investing world who I follow almost obsessively. Two of those all-stars, in my book, are Mabene Faber and Wes Gray.  Both of them take a statistical and research-based approach to investing, building off of the work of many of the greatest investing minds out there. One of their common approaches involves the use of momentum in investing as a way to reduce risk.  I have written about momentum before, and about factor-based investing more broadly, and I believe that we as investors can use factors in a conservative, cost-efficient manner to reduce risk from the onset and potentially increase returns in the long-term.

One of the keys with momentum investing, as implemented by Faber and Gray, is to get out of an asset class once its price has crossed a threshold of poor performance, such as trading below its 200 day moving average. In doing so, investors can avoid staying in the market during some of the worst “drawdowns” or declines. By avoiding the worst part of market declines, investors are more likely to stick with their investment methodology, not psych themselves out trying to time the market, and keep away from other mistakes that investors make during good times and bad. For retirees, avoiding the worst part of market declines can help protect their withdrawal/spending goals during bear markets.

Here are a few other important aspects of momentum investing:

  1. Just as momentum investing can help investors make objective decisions of when to sell an asset, it can also help with objectively determining when and how to make a purchase. It also helps decrease the odds of “catching a falling knife”, which means buying an asset that then continues to decrease in price.
  2. Momentum investing will look bad when the market is going up, because it is not meant to time the bottom of the market (not that any strategy can consistently do so). It takes multiple market cycles (up and down) to show the benefits of this investing methodology.
  3. While almost everyone can benefit from momentum investing, it is even more valuable for people near retirement or in retirement, especially if the investor is taking on more risk with his or her investments or does not have the cushion to withstand a significant bear market.
  4. A momentum investing methodology can be customized based on risk tolerance, proximity to retirement, investment goals and whether taxable or tax-deferred accounts are involved.
  5. There are trade-offs with momentum investing. As mentioned above, it does not attempt to perfectly call a top or bottom of the market and it can under perform a buy-and-hold strategy for a significant period of time. It results in higher fees and taxes than a buy-and-hold strategy. If you tailor a momentum strategy to minimize fees and taxes, then it will more closely mirror buy-and-hold’s risks and returns.  If you attempt to minimize the drawdowns, then you will likely have more false-positives, trading costs and expenses.

I sleep well at night with the stock market at an all-time high not because I think the market is going much higher (I don’t expect it will in the short or medium term) and not because my portfolio is perfectly positioned for whatever happens (that doesn’t exist), but rather because if a bear market sets in with stocks or bonds, then I have an objective, emotionless plan in place to get out, hopefully before the worst of it occurs.

-Richard

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