[In layman’s terms] Are you a momentum or value investor?

are you a momentum investor or a value investor?

🌰In a nutshell: Knowing your investment type is very important in achieving your financial goals. Depending on your preference, you can be either a momentum investor or a value investor. Let’s find out where you fit and the type of strategies you can employ to create the best return.

Momentum vs. value investors

Susan is a visual learner while Ted prefers to absorb information through listening. Susan likes something fast and dynamic where Ted prefers stability and practicality. Susan loves new items and Ted likes to bargain hunt. Susan prefers to invest when the market shows signs of a long stretch of the bull market, while Ted likes to pick up stocks that are valued lower than they should be. Susan is a momentum investor while Ted is a value investor.

The point of the description is not to typify momentum and value investors. Rather, it is to point out that people do have their preferred method of investment as they are quite different and evoke different psychological responses from the investors.

Momentum investors ride the upward trend

momentum investors follow the upward trend

Momentum investors: people who invest in an asset because it is increasing in value.

Why does it work? In short, the momentum investing is based on the idea that the price trend shown in a given stock asset will continue in the next period. In other words, the strong will become stronger and the weak will become weaker.

In most cases, momentum investors look at the performance of the past 12 months in order to gauge the trend.

The point is, you need to ride the big wave when it just turns up, and get off the wave when it starts to topple off.

Normally, people find it hard to get on the wave when the price starts going up. For that psychological reason, investors who are more comfortable with taking risks prefer the momentum investing than people who are risk-averse.

The idea sounds easy in text, but mighty difficult in real practice. How is it even possible?

How does it work?

An explanation lies within the human behavior: latency found among investors in reacting to good/bad news. What does that mean? Let’s suppose a stock price was going down. However, the company just had a breakthrough and released the good news. Surprisingly enough, the good news takes time until it is reflected in the stock price. Why? Because it takes time for investors to only slowly recalibrate their views of the stock.

Investors also rely on historical information to set the expectation of the stock price. They gather information on what the historical high was in the previous year, and how the company has performed in the past and how it is translated into the price of the stock. Therefore, it often takes time for investors to expect a new market highs and lows of the given stock.

Also, investors have the desire to lock in their profits. This desire works in both directions: when assets rise and fall. When their stock rises in price, they want to hold on. When their stock starts depreciating, they hold on and do not sell. When the value starts to finally appreciate again, they then sell the stocks. In the end, many end with the loser stocks and selling the winners.

When the price of stocks starts to appreciate again, it is very likely that new positive earnings surprises will be followed. This is because often the industry as a whole is on the upswing, and companies and industries sometimes hold back on parts of the good news so that they can release them in stages.

While many investors are looking for deeply undervalued stocks so that they can buy them at depreciated prices and wait for them to start increasing in value. While this is a good strategy, it is a much better option to wait until it actually shows the upward swing if you wish to save time and manage the most profitable portfolio.

Value investors look for good bargains

value investors look for good bargains

Momentum Investors: people who look for the deeply undervalued stocks. They buy them and wait for their glory day to come.

Why does it work? It has to work, as it is investing in stocks that are priced lower than what it actually worth according to the value of the company. Simply speaking, if for some reason you can buy a share of Samsung or apple for $10.00 (say that it is a legitimate transaction), why wouldn’t you? The father of the theory is Eugene Fama and his well-known book, Efficient Market Theory. If he is the founder of the school of value investment, the famous pupil would be Warren Buffet.

The point is, you need to study companies thoroughly in the market, find the hidden gem, invest, and wait until it appreciates to its true value.

Sound easy enough? Actually, value investing is easier said than done.

How does it work?

I decided how difficult it is to do this under “how does it work”, as if it was that easy, everyone would do it and it wouldn’t work.

The reason why it works-or doesn’t work-is that it takes tremendous patience. Value investing is a waiting game. You would need to be sure of your decision and ready to wait for years at times. As such, some find this type of investment very boring. It might be a safe and stable way, but lackluster and undynamic. The performance might be very disappointing at times, and you might be prompted to sell it. It is very difficult to stick with the decision. Also, if you need the fund liquidated for some reason fast, this may not be the method of investment either.

Another reason that makes it hard is due to the herd mentality. When the price of the stock stays undervalued for long, pessimism kicks in and people start overreacting. This causes the price of stock to drop even further down. On the other hand, the same herd mentality may hype the price of stock. As such, without a solid fundamental or earnings from the company, popularity kicks in and to drive the demand, overpricing the stock value. This can create bubbles that can be popped at any moment.

What is the best option? Take the best of the both value and momentum investment

The idea is simple. You want to buy the winner stocks and avoid the losers. How would you do that? Do you research to find undervalued stocks in the market? Check their fundamental analysis, and their macroeconomic circumstances. Are they solid ones? Do they have great potential in the future?

quadrant of momentum vs value

Then turn to their 52-week performances. What is the trend? Do they show the likelihood of up swinging? Is the industry that the company belongs to the rise as a whole? Do your due diligence on the market condition.

If you say yes to both categories of questions, then do not miss your window of time to ride the wave at the beginning of the upswing. Play the waiting game and plan a long-term investment. If you can, plan your portfolio in such a way that you can allocate funds into long-term investments that you will not be prompted to sell. Simply monitor them once or twice a year to rebalance them.

Depending on your preference, you may be more inclined to follow the momentum principle over the school of value investing, or vice-versa. However, if you can complement your method by risk-adjust your portfolios and jump in at the right moment, it is likely to improve your performance over time.


References
Jyskecapital.Com, 2020, https://jyskecapital.com/wps/wcm/connect/jcm/3a803826-52b8-432d-af36-f5e253f78fe2/Value_momentum.pdf?MOD=AJPERES&CONVERT_TO=url&CACHEID=ROOTWORKSPACE.Z18_P20418S0N05640Q0MBPDFT1UN5-3a803826-52b8-432d-af36-f5e253f78fe2-mHuV7Vi. Accessed 7 Mar 2020.

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