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