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Nov. 30, 2016, 12:12 p.m. EST

Momentum investing is back, and investors should take advantage

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About Nicholas A. Vardy, CFA

Nicholas A. Vardy is Chief Investment Officer at Global Guru Capital, a fee-only, SEC-registered investment-advisory firm where he manages money for high-net-worth clients. Vardy is also the editor of three investing and trading services at NicholasVardy.com. He appears regularly on the Fox Business Network and CNBC Asia, and is a highly-rated speaker at investment conferences around the globe.

Nicholas regularly contributes his market views on his company blog. You can also follow Nicholas on Twitter @NickVardy or email him at nvardy@globalgurucapital.com.

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In contrast, momentum investing is similar to an elaborate game of musical chairs where the players are vying for a seat before the music stops. As a Financial Times columnist put it a few years ago: "It feels wrong that money can be made this way."

Second, momentum investing is about making money, pure and simple. Value investors serve a noble purpose in identifying unrecognized value in the market, thereby helping to make it more efficient. In contrast, momentum investing is downright cynical, disregarding the fundamentals of the underlying asset, and only reinforcing the market's inefficiencies with its "me too" investing approach.

Third, momentum investing exploits the irrationality of market players. The smart people who won Nobel Prizes for developing modern financial theory are annoyed by irrationality.

In fact, they simply assume it away. In their model, all market participants are the homo economicus — the perfectly rational actor each of these academics aspire to be.

In contrast, momentum investors simply profit from the distortions of the short-term psychology of the stock market.

The challenges of momentum investing

For all its proven successes, few investors trade purely on momentum.

Momentum investing may be simple. But it's not easy.

First, momentum investing is a high turnover, high-cost strategy. Annual turnover often exceeds 100%. Commissions, spreads and capital-gains taxes drag on performance. Momentum also investing takes relentless discipline, and hard work to a level few investors can muster consistently.

Second, momentum feels good when you are in the flow. However, that flow can reverse swiftly. Pullbacks in momentum stocks are often more painful than the overall market. Massive drawdowns can also mess with the most robust investor's psychology.

Third, nothing works all the time. Momentum strategies have underperformed the broader market since 1991. Surprisingly, value has fared even worse. If you are of a contrarian bent, this underperformance may be reason enough alone to give momentum investing a shot

The bottom line?

Modern finance is confused by the statistical success of momentum investing. Simply ignoring investor psychology does not make the momentum anomaly disappear. Humans are not perfectly rational creatures. Nor is human psychology set to change in the near future.

Finally, successful momentum investing also offers the irresistible promise of significant gains over a short period which all stock market investors crave- whether they admit it or not. That fact alone ensures why momentum investing, the most politically incorrect of investment styles, will continue to thrive.

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