- Value factor: Cheaper companies tend to outperform the market over the next 5 years or so.
- Momentum factor: Companies that have performed the best recently tend to outperform the market over the next few weeks or months.
Source: Kenneth French Data Library
The research clearly shows that the momentum anomaly offers the greatest opportunity for outperformance. Further, this anomaly extends outside stocks to asset classes and even residential real-estate. The following chart from our two-page report on momentum shows how holding the top 2 and top 5 asset classes (out of 10 global asset classes) based on recent price performance (momentum) crushes portfolios consisting of the bottom 2 and 5 asset classes.
Source: Yahoo Finance, Butler|Philbrick|Gordillo & Associates
The overwhelming challenge for most investors is that, while these factors obviously work universally over time, they do not work all the time. In fact, as the chart below clearly shows, each of these factors periodically under-performs over periods as long as several years.
Source: Kenneth French Data Library, Butler|Philbrick|Gordillo & Associates
The research clearly shows that the momentum anomaly offers the greatest opportunity for outperformance. Further, this anomaly extends outside stocks to asset classes and even residential real-estate. The following chart from our two-page report on momentum shows how holding the top 2 and top 5 asset classes (out of 10 global asset classes) based on recent price performance (momentum) crushes portfolios consisting of the bottom 2 and 5 asset classes.
The overwhelming challenge for most investors is that, while these factors obviously work universally over time, they do not work all the time. In fact, as the chart below clearly shows, each of these factors periodically under-performs over periods as long as several years.
Unfortunately, it is very difficult to stick with a manager who under-performs despite the overwhelming evidence of the long-term efficacy of their value or momentum approach. This inevitably compels investors to move their portfolios from manager to manager chasing whichever factor has worked the best recently.
Source: Dalbar, 2012
The following chart shows the average investor holding period for each category of mutual funds over the past 20 years. Note that the typical 3 to 4 year holding period shown below is generally insufficient to realize the majority of benefits from either a value or momentum approach, especially when most investors flock to a new strategy only after it has already delivered substantial recent outperformance.
Source: Dalbar, 2012
The negative impact of these portfolio switches to actual investor performance is staggering. The chart below, also from Dalbar shows how the average balanced investor has under-performed stocks by 5.69% per year and bonds by 4.38% over the past 20 years, and failed to keep up with inflation.
It’s important to note that this tendency to herd is a universal human trait that can only be overcome with the acceptance that in markets, our instincts are ultimately destructive. As humans, we are hardwired to make the wrong investment decisions in the absence of a disciplined and systematic investment process.
The lesson is quite simple: When you find a factor that is proven to work over the very long-term, and a manager who is committed to systematically harnessing that factor, stick with him through thick and thin!
For more information on the most persistent and pervasive excess return factor in markets, along with two other powerful techniques - volatility management and active diversification - just click the associated links!
