The Momentum mindset

From my recent note to subscribers

I have spent the last 9-12 months digging deeper into other approaches to investing. I have read up on the momentum style, technical analysis, trading, options and more. The reason was to understand how other investors think

It is easy to become dogmatic about your approach and think only you have access to the ultimate truth. I have been guilty of that. I have seen a few value investors (including friends) talk about these other approaches and that intrigued me to dive deeper.

It has given me a better appreciation of these other styles and understand (NOT predict) the price movement in stocks much better.

I have defined my approach as value investing – buying companies for less than their intrinsic value and then holding them for the long term (2-3 years).  This approach involves deep analysis of the business and its prospects. However an under-appreciated aspect of value investing is the time horizon.

Value investing or in other words convergence of price to value of a company, usually happens in 2+ years. In the short term markets are quite efficient and tend to price the near term quite well. The gap (if there is any) usually closes over the long run.

The approach is sound and has worked for a long time. What has changed ofcourse is the definition of value. If you still follow the traditional approaches of PE, P/B ratios and so on, then you will not do well as markets and economies have evolved a lot in the last 15-20 years.

In comparison, other approaches such as Momentum (where you buy stocks which have done well recently in terms of price performance) have worked quite well in the recent past. This approach is practiced more widely in India and there are a lot of very successful practitioners. The difference however extends beyond just the approach. It also involves a shorter time horizon and a difference in temperament.

Although the upside is good, this approach comes with its own risk in the form of momentum crashes. Investors who practice this form of investing have a methodology (rules based or otherwise) to exit their positions when the momentum turns to reduce the downside.

This often means changing your view and portfolio positions overnight. It is important to recognize which approach fits your temperament and which positions make sense for it. The worst thing to do is to buy a momentum stock with a value investing framework.

The momentum mindset

Even though I am not picking stocks based on momentum (yet), I want to build that mindset into my decision making process. The trading or momentum mindset is more rational, even more so when it is rules based.

Investors who follow the non-discretionary approach in momentum or trading, exit their positions when their system gives the signal to do so. Their effort is to back test the system and validate it. However once that confidence is developed, it is followed with discipline.

On the contrary investors like me, tend to get wrapped up too much with our narratives (or stories). As result, even when external conditions change, we tend to stick to our outdated stories and refuse to exit the position.

I have been guilty of this and even when I do change my mind, tend to get emails accusing me of abandoning a stock as if we should remain married to it forever.

I have been re-thinking my approach and you could see a higher turnover or exits even where I was optimistic or positive earlier. Some of you will hate me for taking small losses when I am wrong. I will treat that as an occupation hazard.

It is far better to take a small loss initially than lose much more later.