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Beware the Bandwagon?

Every investor knows the mantra “buy low and sell high,” but sometimes it can pay to buy high and sell higher. The name for such a strategy is momentum investing. Does it work?

To find out, we looked at data compiled by University of Chicago professor Eugene Fama and Dartmouth College professor Ken French. We found that a portfolio invested in the top 10% of the best-performing stocks over the trailing 12 months going back to 1927 had an average annual return of 20.36%, compared to the average annual market return of 11.90% during the same period.1 So over very long periods, buying stocks that have done better than their peers has delivered outsized returns.

Momentum investing isn’t a one-way street, though. The potential for strong returns comes with increased risk. During the period covered by the data, a portfolio of the top 10% of the best-performing stocks was about 36% more volatile than the broader market.2

Why is there so much volatility with momentum stocks? They tend to move based on supply and demand rather than the financial health of the underlying companies. As a result, reversals can be sharp and rapid.

Another report using the same data set found that a portfolio of the best-performing stocks gained an average of 15% in the three months leading up to a peak in the stock market.3 However, that same portfolio then surrendered all of its gains in the months after the market peaked.

This isn’t to suggest that momentum stocks don’t have a place in portfolios. Researchers have found that combining momentum stocks and value stocks—those with a low price relative to their fundamentals—can be an effective diversification strategy because they tend to perform well at different points in the market cycle. Schwab Equity Ratings® tries to capitalize on this phenomenon. Momentum and value factors, among others, are used to identify stocks that we believe will outperform or underperform the market over the next 12 months.

1Charles Schwab Investment Advisory, Inc., using Fama and French data. Average market return represented by the capitalization weighted index used by Fama and French from 1/1/1927 to 12/31/2013.

2Ibid.

3Mark Hulbert, “Momentum Investing: Big Risk, Rare Reward,” Barron’s, 9/2/2014.

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Important Disclosures

Investors should consider carefully information contained in the prospectus, including investment objectives, risks, charges and expenses. You can request a prospectus by calling Schwab at 800-435-4000. Please read the prospectus carefully before investing.

Past performance is no guarantee of future results.

Schwab Equity Ratings are assigned to approximately 3,000 of the largest (by market capitalization) U.S.-headquartered stocks using a scale of A, B, C, D, and F. Schwab's outlook is that A-rated stocks, on average, will strongly outperform and F-rated stocks, on average, will strongly underperform the equities market over the next 12 months. Each of the approximately 3,000 stocks rated in the Schwab Equity Ratings universe is given a score that is derived from several research factors. The assignment of a final Schwab Equity Rating depends on how well a given stock scores on each of the factors and then how that stock stacks up against all other rated stocks.

Diversification strategies do not ensure a profit and do not protect against losses in declining markets.

This article is for informational purposes only and is not an offer, solicitation or recommendation that any particular investor should purchase or sell any particular security or pursue a particular investment strategy. The types of securities mentioned herein may not be suitable for everyone. Each investor needs to review a security transaction for his or her own particular situation.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions.

Charles Schwab Investment Advisory, Inc. ("CSIA") is an affiliate of Charles Schwab & Co., Inc. ("Schwab").

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