In an investor bulletin that is sure to annoy technical investors, The Securities and Exchange Commission (SEC) lists momentum investing among common behaviors that undermine financial performance alongside naive diversification, familiarity bias, and high mutual fund fees. The bulletin says that the list doesn’t necessarily represent the view of the SEC, but it’s still funny to see such a prominent investment strategy listed alongside cognitive biases.
The original report, written by Seth Elan at the Library of Congress Federal Research Division, was meant to help individual investors understand the behavioral patterns that might get them into trouble.
Active trading opens people up to most ‘common mistakes’
By chance, Elan’s decision to list his nine ‘common mistakes’ in alphabetical order puts one of the biggest right up front: active trading. It’s well known that active trading causes most people to underperform the market. Some people are subject to the disposition effect (selling winners and holding onto losers); others get caught up in the mania and panics that pull stock prices away from fundamental valuations; the familiarity bias causes people to invest in widely covered stocks like Tesla Motors Inc (NASDAQ:TSLA) and Facebook Inc (NASDAQ:FB) and to focus on domestic stocks; and some are too susceptible to headlines, good or bad (what Elan calls noise trading). More than half of Elan’s list boils down to the fact picking stocks is incredibly difficult and most people are bad at it.
Elan also warns people against under-diversification and ‘naïve diversification,’ putting equal weights on all assets instead of balancing risks to meet your investment needs. He also says that people put too much emphasis on mutual funds’ past performance and not enough on how high their fees are, all of which seems like solid advice.
Report calls momentum investing ‘magical thinking’
“Momentum investing is an investment strategy whereby the investor buys securities with high recent returns and sells those with low recent returns, in the expectation that past trends will continue,” writes Elan. “Mohacsy and Lefer equate momentum investing, which is a manifestation of magical thinking and herd behavior, with the Greater Fool Theory.”
You’re not likely to see this site advocate for momentum investing strategies, but they do outperform in some situations and calling them ‘magical thinking’ is pretty harsh. Maybe we can chalk it up to another example of his very first warning: unless you’re one of a few very talented portfolio managers, active trading is a bad idea and short-term momentum strategies don’t make it any better.