Calculating Momentum: Relative and Absolute Momentum

Momentum is the tendency of investments to persist in their performance. There are two types of momentum investing: relative momentum and absolute momentum.

• Relative strength momentum (also called cross-sectional momentum) compares the performance of one asset to other similar assets to predict its future performance.

• You buy the strongest assets and sell the weakest assets over a certain period. For example, a relative momentum strategy might involve buying the top 10% of stocks and short-selling the bottom 10% of stocks over the past year.

• Absolute momentum (also called time-series momentum or longitudinal momentum) uses the asset's own past performance to predict its future performance.

• For example, an absolute momentum strategy might involve investing in an asset if its price is higher than it was a year ago and selling the asset if its price is lower than it was a year ago.

Look-back Period

The look-back period is a key component in momentum investing. This is the amount of time used to evaluate past performance. The optimal look-back period is generally 6 to 12 months. A 12-month look-back period is commonly used in both relative and absolute momentum strategies.

Using Dual Momentum

Dual momentum combines both relative and absolute momentum. A dual momentum strategy might involve:

• Using relative momentum to select the best-performing asset class over the past 12 months.

• Then applying absolute momentum as a filter, investing in the asset class only if its excess return over the past 12 months is positive.

• If the excess return is negative, the strategy would invest in a safer asset, such as short-to-intermediate-term fixed-income securities, until the trend turns positive again.

Advantages of Momentum Investing

• Higher returns: Momentum investing has been shown to generate higher returns than traditional buy-and-hold strategies.

• Reduced risk: Absolute momentum can reduce downside risk by exiting positions early during bear markets.

• Simplicity: Momentum strategies are relatively easy to implement.

Potential Enhancements

Researchers have explored several methods of enhancing momentum strategies, including:

• Price, earnings, and revenue momentum: Incorporating earnings and revenue momentum with price momentum.

• Accelerating momentum: Identifying stocks with accelerating momentum.

• Fresh momentum: Selecting stocks that have recently become winners rather than stocks that have been winners for a longer period.