Is the trend really your friend?

The "efficient market hypothesis" tells us that stockmarkets price shares in a way that perfectly reflect all known information about a firm. It also declares that investors are all rational people who will do whatever delivers them the most profit. Any success in beating the market is the result of luck rather than skill, and apparently successful stockpickers just happen to get lucky frequently.

The trouble is, says The Economist, like many a good academic theory, this one struggles with some rather inconvenient questions. Where were all the rational investors hiding when the dotcom boom put billion-dollar valuations on companies with no profits and barely any sales? Why do stocks often seem to do well at the start of the year and less so during the summer (leading to the well-known advice to, "sell in May and then go away")?

The truth is, of course, that investors are quirky, irrational and prone to what Charles Mackay in 1841 called "the madness of crowds". That's why investors bought into dotcom shares on crazy valuations, hoping that they could flip them on at a profit to an even less rational "greater fool".

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This momentum effect, driving asset prices way beyond any rational valuations, is even more marked in less liquid markets, such as housing. As Tim Bond of Barclays Capital points out in the latest Equity Gilts Study, although many factors influence house prices, none is as important as recent house-price inflation the expectation that property will keep going up "comes to the fore and becomes the key factor".

Equally, if a company grows its profits at 20% a year for five years, many investors happily believe it will do so for another 15 years, despite the fact that 20 years of exceptional growth "is as rare as a vegetarian cat", as The Economist puts it. The end result is that many price trends, whether in housing, shares or commodities, run on for far longer than many market participants expect.

That's all very well but how do you quantify this investor irrationality, let alone profit from it? A recent study from the London Business School claims to be able to answer both questions. According to the research, if you consistently followed a monthly strategy of buying the top 20 stocks of the largest 100, based on the previous year's performance, and selling the bottom 20, you would have made 15.2% a year over the past century, compared to just 9.4% from simply following the market.

Cut the timeframe down to the last 50 years and the respective returns are 18.3% and 13.2%. What's more, switch the study to other developed world stockmarkets and similarly impressive results emerge, which become even more concentrated if the strategy is tested on just the top and bottom ten stocks. In short, momentum investing can make you wealthy.

So why isn't everyone doing it? Largely because there are several big obstacles to overcome. Firstly, you must be comfortable with both buying and shorting shares either using spreadbets or contracts for difference. Then there are the huge transaction costs associated with constantly churning shares enough to wipe up to 50% off your returns, says The Times.

You also need a lot of discipline to stick to mechanically switching holdings each month to reflect updated performance (although information on winners and losers can easily be gleaned from sites such as Digitallook.com). Finally, every now and again momentum investors get horribly skewered when sentiment changes and an existing trend turns round. For example, as John Authers points out in the FT, the strategy would have lost 60% in 2003 when markets rallied after a nasty, but short lived, bear market.

So if precisely replicating the LBS strategy has its pitfalls, are there any other tips that investors can glean from momentum investing? Well, as Justin Urquhart Stewart comments in The Times, contrarian investors would pile into both banks and housebuilders right now on the basis that recent price falls make them cheap. Momentum fans, on the other hand, would expect that both have much further to fall, as the mass expectations that drove the UK's housing market to giddy heights last year slam into reverse.

On the upside, a number of soft and agricultural commodities, as well as the countries that produce them such as Brazil (LSE:IBZL) will continue to do well long term, both because of some sound fundamentals and the fact that they are very much "in vogue". The same goes for gold (LSE:PHGP) and silver (LSE:PHSP), which, give or take the odd correction, are likely to keep on climbing until central banks convince us that they have global inflation back under control which could take some time.