A disciplined approach based on tried and tested factors
Feed-back loops and Momentum
“…a better way of achieving a consistent level of expected return is to adapt to changing market conditions. By evolving a multiplicity of capabilities that are suited to a variety of environmental conditions, investment managers are less likely to become extinct as a result of changes in business conditions”
Andrew Lo, Harris and Harris Group Professor of Finance at MIT; ‘Introducing the Adaptive Market Hypothesis’ Journal of Portfolio Management (2004)
In any complex, adaptive system such as the financial markets where the actions of individuals affect the decisions of others a feed-back loop can be seen to exist. A feed-back loop describes the situation when output from an event in the past will influence an occurrence event in the present or future feed-back loops can be either positive where a move in a certain direction leads others to follow in that direction or negative where moves in a certain direction lead others to move in the opposite direction. Such actions can be called momentum or trending and its existence presents opportunities which can be exploited using a disciplined investment process that reacts to the signals generated by financial markets.
Many studies have been undertaken analysing the predictability of price momentum. It has been established beyond doubt that, more often than not, once an instrument starts moving in one direction it is likely to continue moving in that direction for some considerable time. This analysis has been applied to a range of financial assets from currencies, through to commodities, fixed interest, equities and property. It applies at the individual level as well as groups and sectors.
Studies have also shown that this momentum effect is discernable in areas other than just price. For example, earnings momentum, where the action of an upward or downward move in expected earnings is likely to lead to a move in a similar direction, is well document. Characteristic, thematic, cycle and investor attention are all areas where the momentum effect has been shown to have a significant influence in explaining investor returns.
Whereas traditional finance theory encouraged a deductive approach to investing (i.e. collate as much information as possible and then calculate the impact this is likely to have on the future value of an asset in order to determine whether an investment should be made) a momentum approach in a complex world requires an inductive approach (observe what investors are doing and respond accordingly). This difference in thinking requires a very different approach to investing which is a powerful advantage to momentum investing. Under a deductive approach investors are required to believe that they have a unique insight into why an instrument is attractive and, crucially, that insight is unlikely to change. Such a position is, by definition, inconsistent with how a complex adaptive system works. An inductive method on the other hand seeks to recognise the current state of thinking and assume that it will continue, that is, the momentum will persist. When the thinking (momentum) changes so will the investor's viewpoint.
A significantly different mind set is at work between these two approaches which behavioural finance has demonstrated works to the disadvantage of the investor following a deductive approach. Investors who rely on their analytical ability to identify attractive investments fall into the trap of “anchoring” which blinds them to change in the belief that their original (anchor) analysis was correct. They run the risk of becoming emotionally attached to their decision. On the other hand an investor who is focused on observing what is happening will have no such attachment. History has shown that there is a probability that a trend in motion will remain in the same direction but when it changes that probability will reverse. Thinking in terms of probabilities is central to our approach.