Relative & Absolute Momentum
We hear the term momentum investing a lot. Most of us don’t really understand it. What we understand is in momentum investing we buy stocks which are in momentum, meaning, stocks that are going up. But, there are different types of momentum. Absolute (Time Series) and Relative (Cross-Sectional) momentum are the two main types. Let us understand these two with two very simple examples.
Imagine you are taking a train ride. Relative momentum is wanting to be in the fastest train. So it compares the train speed with all other trains and tells you the one which is running fastest and you jump on to it. Sometime later you check again. And find out if it’s still the fastest. If some other train becomes faster, you switch to the other train. So in relative momentum, we rank the stocks based on their speed and quality of momentum relative to other stocks and select the top ones. And keep switching by checking periodically.
In comparison, absolute momentum just checks if the train is running and running fast. It doesn’t compare with any other train. If the train slows down, we get off. If the train stops we get off. This train may be among the top ones on relative momentum criteria or it may not be. We are okay as long as the train is moving ahead at a decent speed. If we can’t find such trains we wait.
What does it mean in practical terms? The entry and exit points and holding periods differ basically. To take a simple example, in one of our strategies that I use, we will exit a stock even if it is going up but it has become slower than other stocks. Due to this difference in entry and exit and holding period, it is expected to give a diverse set of stocks and the equity curve is expected to behave differently providing us with a diversified combined basket of stocks which has a smoother equity curve.
It may appear the same because in any case, we are buying stocks which have been going up. The first sentence of Leo Tolstoy’s novel Anna Karenina reads, “Happy families are all alike; every unhappy family is unhappy in its own way”. Stocks also behave in a similar manner. They all look similar when they are in their bull phase. But when studied deep, there are a hundred ways of filtering them with different results.
Gary Antonacci’s book Dual Momentum is a good read to explore this subject in a bit more detail.
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