Hall of Fame baseball player Babe Ruth famously said, “Yesterday’s home runs do not win today’s games.”
It’s the same advice the Certified General Accountants Association of Canada (CGA-Canada) is giving when it comes to investing: Just because your favourite stocks have been hitting it out the park lately, doesn’t mean the trend will continue.
A new CGA-Canada study of Canada’s capital markets shows that historical prices of securities aren’t so helpful when it comes to predicting future performance.
The study looks at the momentum effect, which is an anomaly in the market that sees the volume or price of a stock rise. The implication is the price will keep rising in the future.
Despite claims the momentum effect is useful for investors, the CGA-Canada study of 180 securities over a 21-year period is more skeptical of the strategy.
“There is some evidence that the strategy could be successful for one-to-two weeks, but benefits dwindle progressively over a three-month period,” says Kamalesh Gosalia, the report’s author and a principal of accounting and assurance standards at CGA-Canada. “Momentum trading can be a very high-risk strategy and is not suitable for novice investors.”
Still, Gosalia notes that momentum trading will continue to "catch the imagination" of investors. He then lays out the risks, which include:
- Initiating a position too soon, before a momentum move is confirmed.
- Closing a position too late, after saturation has been reached.
- Missing the changing trends, reversals or signs of news that take the market by surprise.
- Keeping a position open overnight. Stocks are particularly susceptible to external factors occurring after the close of that day’s trading – these factors could cause radically different prices and patterns the next day.
- Failing to act quickly to close a bad position, thereby riding the momentum train the wrong way down.
Finally, Gosalia notes there can be big rewards for successful momentum traders, who have the stomach for it.
"With a proper understanding of the technique, sufficient knowledge of the risks, and willingness to take an occasional loss, momentum trading offers an appealing choice for the aspiring trader who enjoys living on the edge," says Gosalia.
Again, he notes, it isn't for everyone. “The market is unpredictable and investment success is often based on an active investor doing independent research and a little good luck."