Friday, June 19, 2015

The Philosophy of Momentum

What is momentum and why is it so pervasive? This is something I think about a lot.

Momentum in Everyday Life

First off, momentum is the tendency for something to continue in the short-term doing what it’s been doing. It’s Isaac Newton’s first law, which applies to all physical objects having a mass and velocity.

When we are driving a car on a flat road and take our foot off the gas pedal, the car continues to move forward for a certain period of time. When a train is approaching a station, the operator needs to apply the brakes well in advance since the train wants to keep pushing forward. When the captain of a cruise ship sees the ship is heading in the wrong direction, it takes a while to change course. These are simple examples of momentum as applied to physics.

Momentum not only applies to physics and financial markets, but life in general. Dorsey Wright pointed out:

"Momentum is pervasive, both in the financial markets and in life in general. Andre Agassi found that past decisions created a momentum-effect in his life that made it very difficult for him to change course."

Think about your career for example. You spend a lot of time going to school and then gaining experience. Once you get good at a job, you have momentum. Trying to make any career path change at that point is slow since it often takes a lot of time and effort to get good at something else.

I recently started going to a local cooking workshop that is held in my area once a month. The organizer was telling us how it took a lot of effort initially to find a venue with a kitchen, volunteers, come up with workshop ideas and then build up a sizable attendance. "But now that we've been doing this for two years, it has gained momentum. People just show up without us having to do any advertising."

Another example is with car traffic. Suppose you are driving on a highway with two lanes going each way and you need to reach your destination efficiently. You observe for a while that cars are travelling faster in one lane. Without thinking twice, you switch into that lane because it has relative momentum. 

Momentum Investing

Let’s shift our focus to momentum investing. We have seen momentum backtest results going back over 200 years showing its strong persistence. But we need to discuss why this anomaly exists in financial markets and why we expect it will continue.

Blogger Miles Dividend recently wrote a nice blog post looking at this very topic. He says that from an individual investor’s point of view…

"…momentum is simply human beings’ inexorable tendency to chase performance. Think about the first time you had to make an investment decision. What did you look at first? I’m guessing that one of the first things that you were drawn to, like a moth to flame, was the past performance for the various funds listed. I know that was the case for me."

In Dual Momentum Investing, Gary Antonacci of Optimal Momentum has a whole chapter dedicated to human behaviour. Gary shows that behavioral biases (such as anchoring, herding, and the disposition effect) can cause stocks to underreact on a short-term basis and overreact longer term. It takes time for investors to realize what’s going on, seeing their friends & neighbours getting rich, before they feel compelled to jump in too. The market builds momentum, as price gains beget even more price gains. Even Isaac Newton, the father of momentum, was sucked into the power of emotional biases during the South Sea bubble:

Source: Jeremy Grantham, GMO, “On the importance of asset class bubbles,” Jan 2011

Momentum investing works not only due to our individual behavioral biases, but also because of the way large fund managers, businesses and economies operate.

Miles discusses fund managers by saying:

"...on an institutional level transactions occur much slower as funds move away from losing funds and towards winners. This latency is caused by the inherent cost of moving large sums of money, and the constraints on moving large amounts in and out of funds."

I can elaborate on this by saying that it takes time for economic data to be generated and for fund managers to react to that data. On top of that, fund managers need to slowly build or liquidate positions so as not to affect price and hence get the best trade execution. When large positions are being built, this causes a basing/accumulation phase. When large positions are being liquidated, this causes a topping/distribution phase. The chart below depicts this and is the main concept behind what is known as the “Wyckoff Method.

The exact same reasoning can be used to describe momentum seen in large economies. Miles writes:

"When an economy begins shrinking, it takes time to for those in power to recognize that it is in fact shrinking. And when second order actions occur, and interest rates are dropped by central banks, and stimulus bills are passed by governments, it takes time for the pain to work its way through the system, and for the corrective actions to have any effect at all."

I can give a further example of how momentum applies to the way a large company operates. It takes some time for a company’s management to discover any failing business units, take cost cutting measures, improve those units and/or diversify into new ones, and then finally see the benefits of their efforts. Hence, weak companies continue to stay weak in the short-term, and vice versa for strong companies.

Jim Collins, author of "Good to Great" explains the role that momentum plays in getting a company to become successful:

"Picture a huge, heavy flywheel. It’s a massive, metal disk mounted horizontally on an axle. It's about 100 feet in diameter, 10 feet thick, and it weighs about 25 tons. That flywheel is your company. Your job is to get that flywheel to move as fast as possible, because momentum—mass times velocity—is what will generate superior economic results over time. 
Right now, the flywheel is at a standstill. To get it moving, you make a tremendous effort. You push with all your might, and finally you get the flywheel to inch forward. After two or three days of sustained effort, you get the flywheel to complete one entire turn. You keep pushing, and the flywheel begins to move a bit faster. It takes a lot of work, but at last the flywheel makes a second rotation. You keep pushing steadily. It makes three turns, four turns, five, six. With each turn, it moves faster, and then—at some point, you can’'t say exactly when—you break through. The momentum of the heavy wheel kicks in your favor. It spins faster and faster, with its own weight propelling it. You aren't pushing any harder, but the flywheel is accelerating, its momentum building, its speed increasing. This is the Flywheel Effect"

Thus, we see that there are very deep-seated mechanics that have made momentum investing so successful in past centuries and why it should continue being successful. It simply takes time for markets to build a new uptrend and time for it to change that trend. Hence, in the short-term markets continue trending in the same direction. This is largely because of behavioral biases and the natural lags between when large fund managers, businesses and economies discover a change is needed and when the effects of that change become visible.

History has shown that changing the direction of a giant ship like the S&P 500 took a while. From 1982-2000, 2003-2007 and 2009-Present, US stocks went in one direction: Up. Before the 2000-2003 and 2008-2009 bear markets, it took over a year-long topping formation before the market changed course. It’s for this reason that momentum investing and trend following in general works.


  1. Great first post. I enjoyed your point about the inherent slowness of decision making in large companies. Big entities almost cannot be agile, and few things are larger than the world economy.

    I will certainly follow your future posts closely.

    Vancouver BC certainly seems to be the epicenter for Dual Momentum , and having just returned from a vacation week there, it is definitely the epicenter for Shang Hai Soup dumplings!

    Keep up the great work...

    Alexi (Miles Dividend MD)

    1. Thanks Alexi! Glad you enjoyed it. I've been reading your blog regularly and love your take on momentum as well. You can see this post was inspired by what you wrote.

  2. Great posting Gogi! Loved the analogies you made in discussing momentum investing. They were all very effective.

    1. Thanks for the feedback, Harv - really helps. Hoping to keep things simple here

  3. Hello
    As a french investor, I was very interested by your article you posted on Gary Antonacci'blog. You suggest to always keep invested on the US stock exchange. But if I have done that my portfolio would have performed 8.14 % with VOO versus 31 % with a similar ETF in euro on the Paris stock exchange. The difference is huge ! wouldn't it be better to use momentun between the two stock exchange ?

    1. Pierre, when you invest in VOO on the US stock exchange, you are converting your Euros to US dollar and so you're exposed to the USDEUR exchange rate. Therefore, you want to be looking at VOO priced in Euros not in US Dollars.

      When you do this, you will see VOO would have made European investors 31% (the same return you'd make buying a similar ETF on a European stock exchange) over the last year and American investors only 7%. I have shown this on the chart here:

  4. Hello Gogi, thanks for reply

    When you said "the ideal way for foreign investors to implement GEM is to permanently have their portfolio on the US exchange", it meant buying etf priced in euro or in USD ?
    Because it must be worth the risk for as it's not tax free, my return may be reduced by up to 30 %( in my case but it may be heavier) !
    And I'm not talking about the transaction fees ! whereas staying on my local stockexchange (in euro ) I can avoid it through a tax free investment. The drawback is the choice is reduced : no etf tracking ACWI ex US or us aggregate.

    1. When you're on the US exchange, you're buying the ETF priced in USD and watching the performance of the ETF in Euro.

      I do not know how tax-free accounts work in Europe, so I can't comment on that. I only know that in Canada, we are allowed to invest in US stocks in our tax-free accounts without penalties. If Europe does not offer this, then you should invest on your own exchange

  5. Hi Gogi, I have red your post in Antonacci's book. I don't find any e-mail to contact you and for this reason I try here.
    I'm a non-US investor and I'm interested in GEM. I have seen that anything we try without think in currencies works well or not bad, but my point is for instance if I invest the money in GEM and at the same time I buy the same amount of USD I must have the same results that US Investor GEM. Isn't it? Thanks so much for your opinion anb for your blog. (As you can see, my english is no so well...but I'm on it)

  6. Great job Gogi!!! I need to talk to you about your time at Pretium. Can you contact me at 410/602-4028? Thank you. My email is

    David Cohen

  7. Great job Gogi!!! I need to talk to you about your time at Pretium. Can you contact me at 410/602-4028? Thank you. My email is

    David Cohen

  8. How do you calculate momentum from price data? Is it purely the increase/decrease in price between today's price and the price a year ago (assuming a period of 12 months) plus any dividends expressed as a percentage of the earlier price?


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