Momentum And Risk Management

"Real investors" often make fun of momentum investing, dismissing it as mindless trend following that ultimately destabilizes markets by setting up a dangerous positive feedback loop. The feedback loop accentuates whatever trend is already in place until it becomes unsustainable, at which point the trend collapses dramatically. What markets need is real investors who know a bargain when they see one. They buy when prices are going down, and sell as prices move up. This adds stability to markets and provides a decent investment return.

This characterization is unfair to momentum investors. Buying on strength and selling on weakness sounds like mindless trend following. But this trading pattern is exactly the trading pattern that you would expect if somebody were trying to replicate the effect of owning a call or a put. And that is not a crazy strategy since people like the pattern of returns associated with owning options. The potential gains are much greater than the potential losses. The fly in the ointment, of course, is that winning is less likely than losing. But if the amplitude advantage is big enough to make up for the frequency disadvantage, you'll do fine in the long run.

Although people think of momentum investors as ultra-aggressive investors who buy more and more stock at higher and higher prices, the fact is that the momentum investor may be a more prudent risk manager than the contrarian investor. Momentum investing has two rules: Buy on strength, and sell on weakness. The first rule is the aggressive rule. It tells you to increase your position to take advantage of a continuation in the trend. The second rule is a defensive rule. It tells you to reduce your positions when they are moving against you.

If you're a momentum investor and a position moves against you, your first instinct is to reduce or eliminate the position. If you're a contrarian investor, and a position moves against you, your first instinct is to add to the position. The momentum investor is very focused on cutting losses. His motto is, "The first loss is the best loss." The contrarian investor is more likely to average down when a position moves against her. If the stock was cheap at $50, it's even cheaper at $45, so why not buy more?

Mindless momentum investing and mindless contrarianism are both untenable strategies. At the extremes, the momentum investor becomes so averse to loss that he has no staying power. The contrarian investor averages down so mindlessly that she winds up accumulating bigger and bigger positions in stocks that eventually go to zero. The extreme momentum investor is too quick to acknowledge that he was wrong. The extreme contrarian never admits that she was wrong: Every decline in price presents a better buying opportunity. But, as Keynes observed, a bargain that remains a bargain is not a bargain.

Selling on weakness may sound cowardly, but it can be the height of prudence. Buying on weakness may sound brave, but it may be merely foolhardy. So every money manager faces a struggle between two opposing instincts. Some managers fall pretty clearly on the momentum side: They are quick to take losses. Others fall more clearly on the contrarian side: They are more patient about enduring losses and more willing to think about averaging down. The challenge for the investor in hedge funds is to try to figure out where on the spectrum the manager is located. Since skilled managers are reasonable people who try to avoid the extremes, this can be a formidable task.

The willingness to take losses early is especially critical for the leveraged investor. It is better to take the loss early, and voluntarily, than to take the loss later, and involuntarily, in response to a margin call. Not surprisingly, the "cut-your-losses-early" principle is widely followed by major banks, brokers, and other institutions that have large trading positions in the markets. These are leveraged institutions that all follow strict risk control disciplines that force them to exit losing positions. This behavior, needless to say, contributes to market volatility since it means that large positions are held in weak hands. And it means that there are major positive feedback loops in the markets: Initial selling triggers further selling, which in turn triggers still more selling.

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