Investors tell all manner of tall tales when they get together. But they really perk up when the conversation turns to the hot stocks of the moment.
Alas, my grey cells seize up when my friends ask me to pick my favourite stock because the idea of choosing just one seems like an act of hubris – or at least overconfidence. I prefer baskets of stocks selected using strategies with successful track records, which are usually less volatile than a single hot stock and often produce better results.
Speaking of hot stocks, a simple momentum strategy illustrates the dangers of focusing on a single top performer.
In Canada, my simple momentum strategy starts with the largest 300 common stocks on the Toronto Stock Exchange sorted by their total returns over the prior 12 months. Momentum portfolios of different sizes are then formed by picking the top prior gainers. The portfolios are then refreshed monthly and equally weighted. (The returns herein are based on monthly data from Bloomberg and include dividend reinvestment but not fund fees, commissions, inflation or other trading frictions.)
For instance, simple momentum portfolios with 10, 20 and 30 stocks provided average annual returns of 17.6 per cent, 18.4 per cent and 18 per cent, respectively, from the end of 1999 through to the end of April, 2023. The stock market, as represented by the S&P/TSX Composite Index, gained an average of 6.7 per cent annually over the same period. Momentum was a winning strategy.
The excellent results come with a few caveats. Importantly, the momentum portfolios require persistence and effort to implement because they are rebalanced monthly and roughly 30 per cent of their stocks were swapped for new ones each month. The frequent changes tend to boost frictional costs in the form of commissions, taxes and the like.
In addition, the momentum portfolios were roughly 80 per cent to 140 per cent more volatile than the market index, which makes them hard for many investors to hold through thick and thin.
Investors might be tempted to reduce costs by shrinking the number of stocks in the portfolio to five from 10 or even the single top performer over the prior 12 months. But concentrating an already volatile strategy can have disastrous consequences in downturns as shown in the accompanying graph.
Generally speaking, the momentum portfolios with fewer stocks fared poorly in the big crashes of the past 23 years and they all fared worse in downturns than the market index.
For instance, the market index declined 43 per cent when the internet bubble burst in the early 2000s while the 10-stock portfolio tumbled 71 per cent and the five-stock portfolio declined 76 per cent. The one-stock portfolio plunged 87 per cent – and it has yet to fully recover to its former high.
Similarly, the market index fell 43 per cent in the wake of the financial crisis of 2008 while the 10-stock portfolio sagged 57 per cent and the five-stock portfolio plunged 74 per cent. The one-stock portfolio suffered another horrible drubbing and basically gave up the ghost.
The long-term returns of the concentrated momentum portfolios were also worse than those of their larger siblings. The five-stock portfolio gained an average of 9.9 per cent annually from the end of 1999 through to the end of April, 2023, while the market index gained an average of 6.7 per cent annually. The one-stock portfolio was a disaster. It turned each $1,000 invested into $2.21 over the same period – not including commissions.
Picking the top stock turned the simple momentum strategy from a winner into a loser. It’s one reason why you should ask for a basket of picks the next time a friend extols the virtues of their favourite stock.
You can find the stocks in the 30-stock momentum portfolio and updates to many of the other portfolios I track for The Globe and Mail here.
Norman Rothery, PhD, CFA, is the founder of StingyInvestor.com.