Dual Momentum Investing

1. Momentum is the Premier, Enduring Market Anomaly.

The academic community now accepts momentum as the “premier anomaly” for achieving consistently high risk-adjusted returns.

A historical truth. The concept of momentum—that investments persisting in their performance—is not new; it dates back to Isaac Newton's laws of motion and was articulated by David Ricardo in 1838 as "Cut your losses; let your profits run on." Early 20th-century traders like Jesse Livermore and Richard Wyckoff built fortunes on trend-following, while quantitative pioneers like Arnold Bernhard and H.M. Gartley developed systematic momentum strategies. The first scientific study by Cowles and Jones in 1937 painstakingly confirmed that strong stocks tended to remain strong.

Modern validation. Despite initial academic skepticism, rigorous research in the 1990s, notably by Jegadeesh and Titman, solidified momentum's standing. Their work, and hundreds of subsequent studies, demonstrated that past winners continue to outperform past losers across nearly all asset classes and over vast historical periods.

• Momentum works across U.S. and foreign equities, industry groups, global government bonds, corporate bonds, commodities, currencies, and real estate.
• It has been effective in U.K. equities since the Victorian age and U.S. equities back to 1801.
• Unlike other anomalies that disappeared after discovery, momentum has persisted, earning it the title of "premier anomaly" from even its former critics like Eugene Fama and Kenneth French.

A powerful force. This enduring effectiveness suggests momentum is a fundamental market force, not a fleeting statistical fluke. It offers a robust, time-tested strategy for investors seeking consistent, risk-adjusted returns, standing in stark contrast to many other investment theories that have failed empirical tests.

2. Traditional Finance Models Often Fail in the Real World.

In the end, a theory is accepted not because it is confirmed by conventional empirical tests, but because researchers persuade one another that the theory is correct and relevant.

Flawed foundations. Modern finance, despite its mathematical elegance, often rests on shaky assumptions that don't reflect real-world markets. Harry Markowitz's Mean-Variance Optimization (MVO), while groundbreaking, is highly sensitive to input errors and often produces unstable, impractical portfolios. The Capital Asset Pricing Model (CAPM), a simplified alternative, also consistently failed empirical tests, leading its creators, Fama and French, to call it "empirically vacuous."

• MVO: Unstable results, sensitive to inputs, often outperformed by simple equal weighting.
• CAPM: Failed empirical tests, high beta stocks underperformed, low beta stocks overperformed.
• Black-Scholes: Underestimates extreme price movements, relies on flawed normal distribution assumptions.

Ignoring reality. These models often assume normal price distributions and independent price movements, assumptions famously challenged by Benoit Mandelbrot, who showed that market prices exhibit "fat tails" (more extreme events) and clustered volatility. This fundamental disconnect means models like Black-Scholes can drastically underestimate market risk, contributing to financial crises like the Long-Term Capital Management debacle and the 2007-2008 global financial crisis. As Paul Volcker noted, "unjustified faith in rational explanations and market efficiencies" played a role in these crises.

Beware of complexity. The pursuit of increasingly complex factor models (with over 82 published factors) to explain market behavior often leads to "data snooping" and "false discoveries." Many of these factors, when rigorously re-examined, prove to be statistically insignificant or disappear over time. This highlights a critical lesson: elegant mathematical models, while appealing, can be misleading if they prioritize theoretical beauty over empirical truth and real-world applicability.

3. Behavioral Biases Drive Market Anomalies and Investor Underperformance.

People can foresee the future only when it coincides with their own wishes, and the most grossly obvious facts can be ignored when they are unwelcome.

Irrational human nature. While some argue momentum profits compensate for risk, a more compelling explanation lies in human psychology. Behavioral finance demonstrates that investors consistently act irrationally and predictably, causing prices to deviate systematically from fundamental values. These deeply ingrained biases create market inefficiencies that momentum strategies can exploit.

• Anchoring & Underreaction: Investors cling to past information, slow to adjust to new data, causing initial underreaction to news.
• Confirmation Bias: People seek information that confirms existing beliefs, ignoring contradictory evidence, reinforcing trends.
• Herding & Overreaction: Following the crowd, buying rising assets and selling falling ones, amplifies trends and leads to overreaction.
• Disposition Effect: Investors sell winners too early to lock in gains and hold losers too long, delaying price discovery and prolonging trends.

The cost of emotion. These biases lead to significant investor underperformance. The average U.S. equity investor lagged the S&P 500 by over 4% annually over 20 years, largely due to poor timing decisions driven by fear and greed. The greater the volatility, the more pronounced this effect, as seen with CGM Focus fund shareholders who lost 10% annually while the fund gained 18.2%.

• Investors buy near market highs and sell near market bottoms.
• They are often under-diversified, holding volatile, correlated "lottery-style" stocks.
• Overconfidence leads to excessive trading, further eroding returns.

Exploiting human flaws. Momentum strategies, by systematically following trends, effectively profit from these predictable human behaviors rather than falling victim to them. Since human nature and its underlying psychological and physiological drivers are unlikely to change, the persistence of these behavioral biases suggests momentum will continue to be an effective strategy.

4. "Deworsification" and High-Cost Alternatives Undermine Returns.

Diversification may preserve wealth, but concentration builds wealth.

The illusion of diversification. While diversification is crucial, an indiscriminate pursuit of it can lead to "deworsification"—adding assets that offer little benefit while incurring significant costs. Many investors, seeking higher returns or reduced risk, flock to asset classes and strategies that historically underperform or come with prohibitive fees.

• Bonds: Historically, U.S. long-term government bonds have delivered a meager 1.9% real annual return (1900-2013), with negative real returns for decades. Current low yields suggest poor future returns, and rising interest rates could lead to substantial losses.
• Commodity Futures: A zero-sum game with no inherent risk premium for long-only positions. Increased institutional participation has turned the historical "roll yield" negative, and "front-running" costs further erode returns. Correlations with equities have also risen, diminishing diversification benefits.
• Hedge Funds & Private Equity: Despite high fees (2% management, 20% profit share), these often underperform simple index funds. Studies show hedge funds, in aggregate, capture most or all excess returns, leaving little for investors. They also suffer from high leverage, lack of transparency, and declining diversification value.

Smart Beta's hidden costs. "Smart beta" strategies, while marketed as superior alternatives to capitalization-weighted indexes, often merely replicate existing factor tilts (like value or small-cap) at higher costs. Their apparent outperformance is frequently due to these factor exposures, which can be accessed more cheaply through traditional ETFs.

• Fundamental Indexation: Often a value tilt, not necessarily superior to cap-weighting.
• Equal-Weighted Indexes: Mimic small-to-mid cap exposure but with higher turnover and costs.
• Low Volatility Portfolios: Can suffer from high turnover, sector concentration, and tracking error.

Focus on high premium. Instead of chasing complex, high-cost alternatives, investors should focus on assets with a proven, high-risk premium, primarily equities. Dual momentum allows for dynamic allocation to these high-return assets while managing risk, avoiding the drag of "deworsification" and excessive fees.

5. Absolute Momentum is Your Essential Downside Protector.

The most important rule in trading is: play great defense, not great offense.

Beyond relative strength. While relative strength momentum compares an asset to its peers, absolute momentum (or time-series momentum) assesses an asset's performance against its own past. It simply asks: "Has this asset been going up or down over the look-back period?" If up, stay invested; if down, exit to a safe harbor like short-term bonds. This seemingly simple rule is a powerful trend-following mechanism.

Superior risk management. Absolute momentum's greatest advantage is its ability to dramatically reduce portfolio downside vulnerability by identifying and exiting positions early during bear markets. Unlike relative momentum, which can still expose investors to significant drawdowns, absolute momentum acts as a dynamic stop-loss, preserving capital.

• Reduced Volatility: Significantly lowers standard deviation compared to buy-and-hold.
• Lower Maximum Drawdown: Cuts peak-to-valley losses by a substantial margin.
• Higher Sharpe Ratio: Achieves better risk-adjusted returns.
• Regime Change Detection: Effectively shifts out of risky assets when trends turn negative.

A universal overlay. Research confirms absolute momentum's robustness across diverse asset classes (equities, bonds, commodities, currencies) and over a century of data. It consistently delivers higher Sharpe ratios and lower drawdowns, even after accounting for transaction costs. This makes it an invaluable "trend-following overlay" for any asset or multi-asset portfolio, offering a low-cost alternative to complex hedging strategies and a way to mitigate the emotional pitfalls of market downturns.

6. Dual Momentum: The Simple Path to Superior Risk-Adjusted Returns.

It is this elegant combination of relative and absolute momentum that translates overall into higher expected returns with lower expected risk.

The best of both worlds. Dual momentum combines the strengths of both relative and absolute momentum into a single, powerful strategy. It first uses relative momentum to select the best-performing asset (e.g., U.S. vs. non-U.S. equities) over a 12-month look-back period. Then, it applies an absolute momentum filter: if the selected asset's excess return over the past year is positive, invest in it; if negative, move to a safe asset like aggregate bonds. This strategy, dubbed Global Equities Momentum (GEM), is both simple and highly effective.

Exceptional performance. Over 40 years (1974-2013), GEM delivered an average annual return of 17.43% with a 12.64% standard deviation, a 0.87 Sharpe ratio, and a maximum drawdown of 22.7%. This nearly doubles the annual return of a global equity index (ACWI) while reducing volatility by 2% and cutting maximum drawdown by almost two-thirds.

• Higher Returns: Significantly outperforms global equity benchmarks.
• Lower Risk: Reduced volatility and dramatically smaller drawdowns.
• Higher Sharpe Ratio: Quadruples the risk-adjusted return compared to ACWI.
• Low Turnover: Averages only 1.35 switches per year, minimizing transaction costs.

Robust and adaptable. GEM's consistent outperformance across decades, including severe bear markets, demonstrates its robustness. Its ability to adapt to changing market regimes—leveraging relative strength in bull markets and absolute momentum for defense in bear markets—makes it a versatile strategy. Furthermore, GEM can be tailored to different risk preferences by combining it with a fixed allocation to bonds for conservative investors or using leverage for aggressive ones, all while maintaining its superior risk-adjusted profile.

7. Simplicity and Robustness Trump Complexity and Over-Optimization.

Perfection is achieved not when there is nothing more to add, but when there is nothing left to take away.

The perils of complexity. In investing, simplicity often outperforms complexity. Overly complex models, especially those with many parameters, are prone to "overfitting" or "data snooping"—they perfectly "predict" the past but fail miserably in the future. This is because financial data is noisy and non-ergodic, meaning short historical periods are often not representative of long-term market behavior.

• Data Mining: Testing too many strategies or parameters can lead to finding spurious correlations that are merely due to chance.
• Overfitting: Models become too rigid, molded to past data, and lose predictive power for the future.
• Limited Data: Relying on short data sets (e.g., 15 years) for backtesting is dangerous, as market regimes change.

GEM's enduring strength. Dual momentum, particularly the GEM model, stands out for its parsimony and robustness. Its core principle—a 12-month look-back period—has been validated across hundreds of studies, diverse markets, and over two centuries of data, minimizing data-snooping bias. This extensive out-of-sample validation provides high confidence in its future effectiveness.

• Validated Look-back: The 12-month period is consistently optimal for both relative and absolute momentum.
• Minimal Parameters: Reduces the risk of overfitting.
• Broad Applicability: Works across various asset classes and market conditions.

Trust the proven. While there are always attempts to "enhance" momentum with more sophisticated techniques (e.g., proximity to 52-week highs, accelerating momentum), these often introduce complexity, increase transaction costs, and lack the extensive historical validation of simple dual momentum. The lesson is clear: stick to what is deeply proven and inherently simple, rather than chasing marginal, unproven improvements that may be artifacts of data mining.

8. Discipline is Paramount: Trust the Model, Not Your Emotions.

The investor’s chief problem and even his worst enemy is likely to be himself.

The human element. Even with a robust, high-performing strategy like dual momentum, the greatest challenge for investors remains their own behavior. Our innate psychological biases—overconfidence, loss aversion, herding—can tempt us to deviate from the model, especially during periods of underperformance or market volatility. This "tinkering" or emotional decision-making is often counterproductive, turning a winning strategy into a losing one.

Adherence is key. The success of dual momentum hinges on unwavering discipline. The model will inevitably experience periods of underperformance, particularly when markets rebound sharply from deep bear market lows, as trend-following strategies inherently lag. During these times, it is crucial to:

• Resist tinkering: Avoid modifying the model based on short-term results or personal opinions.
• Maintain patience: Understand that much of the outperformance occurs during bear markets, which are less frequent but highly impactful.
• Follow signals slavishly: As systems trader Jim Simons advises, "You do whatever the hell it says no matter how smart or dumb you think it is now."

A new paradigm. Dual momentum offers a new investment paradigm that aligns with market forces and exploits behavioral biases rather than succumbing to them. Its continuing effectiveness is supported by the enduring nature of human psychology. By embracing this disciplined, rule-based approach, investors can overcome their own worst enemy—themselves—and embark on a rewarding investment journey, leaving behind the "wall of worry" for a path of consistent, risk-adjusted growth.