Make momentum work for you

Update: read Is the trend really your friend? for more on momentum investing

Forget trawling through accounts and worrying about p/e ratios, says James Chapman in the Investors Chronicle. According to momentum investors, it is simply not necessary. Instead, if you want to make money, you just buy shares that are already going up - ideally those that performed best over the past three or six months - and sell them three or six months later. This may sound simple, but it does seem to make sense as a strategy.

Take the work of Sheridan Titman of the University of Austin in Texas. He found that investors buying shares displaying strong momentum would have beaten the US market between 1965 and 1993. And this is not unique to the US. According to J Spencer Martin of Arizona State University, buying the 20 best-performing UK shares of the previous six months and shorting the worst performers would have beaten the All-Share index by 1% a month between 1999 and 2000. An Investors Chronicle study from 1997 to 2004 “produced equally impressive results”. No wonder then that, although most fund managers are loathe to admit it, they “tend to employ some sort of momentum investing strategy”.

But getting this right requires concentration. You have to be prepared to buy and sell shares in a relatively short period (the maximum time is usually six months). Buying strongly performing shares in the hope of outperforming the market over a longer timeframe does not work, or so says a 1985 study by US economists DeBondt and Thaler. Over a five-year period, for example, shares with the lowest returns tend to have the best returns over the next five years.

Momentum investing also works best when there are established market trends, either up or down. What “wreaks havoc” are sharp changes in market direction, as has been clear over the last few years. Momentum worked well in the bear market of 2001 and 2002, but poorly in 2003 when the bear market reversed. The upshot is that there is no guarantee that a one-off selection of momentum picks will outperform (as with any mechanical strategy), but if you are prepared slavishly to adopt momentum investing year-in, year-out, you should do well.

The ten stocks momentum investors would buy now (ie, those that have had the strongest share price relative to their 60-day moving averages in the FTSE 350 as of 12 March) are: mmO2, Reuters, Rolls-Royce, Cairn Energy, Corus, EMI, Serco, Britannic Group, Taylor & Francis, and Spirent.