When it comes to Dual Momentum investing, understanding the two core concepts—relative momentum and absolute momentum—is essential for mastering the strategy. These two approaches to measuring momentum work together to identify both the strongest performing assets and the right times to invest or step out of the market. In this article, we’ll dive deeper into each of these types of momentum, explaining how they work and why their combination creates such a powerful investment strategy.
What Is Relative Momentum?
Relative momentum is the practice of comparing the performance of different asset classes to one another over a specific period. This allows investors to rank the assets and identify the top performers. The core assumption is that an asset that has outperformed its peers over the past 6-12 months is more likely to continue outperforming in the near future.
How It Works
For example, let’s say you’re tracking three major asset classes: U.S. stocks, international stocks, and bonds. Over the last 12 months, U.S. stocks have returned 10%, international stocks 5%, and bonds 3%. Based on relative momentum, U.S. stocks would be considered the top performer and, therefore, the best investment option according to this strategy.
Key Benefit: Relative momentum helps you allocate your investments to the asset class that’s currently leading the market, allowing you to ride upward trends and maximize your returns.
What Is Absolute Momentum?
Absolute momentum (sometimes called time-series momentum) is a different approach. Instead of comparing multiple asset classes, absolute momentum evaluates an asset’s performance relative to its own historical performance. This method answers a key question: Is the asset moving up or down compared to its past?
If an asset has a positive return over a given period (typically the past 12 months), it is said to have positive absolute momentum, meaning it’s in an uptrend. If the return is negative, it has negative absolute momentum, signaling a downtrend.
How It Works
Let’s look at an example using U.S. stocks. Suppose U.S. stocks have risen by 10% over the past year. Since the return is positive, absolute momentum would signal that this asset is in an uptrend and suitable for investment.
However, if U.S. stocks had a negative return, say a 5% loss, absolute momentum would recommend shifting out of that asset—likely into safer investments like bonds or cash.
Key Benefit: Absolute momentum adds a layer of risk management by signaling when it’s time to exit an asset class that’s losing value, helping you avoid major drawdowns.
Why Combining Relative and Absolute Momentum Works
The magic of the Dual Momentum strategy comes from combining both relative and absolute momentum into a single, cohesive approach. While relative momentum ensures that you’re always invested in the best-performing assets, absolute momentum adds an extra layer of protection by keeping you out of declining markets.
Practical Example
Let’s revisit our earlier example with U.S. stocks, international stocks, and bonds:
- Based on relative momentum, U.S. stocks are the top performer.
- Next, you apply absolute momentum to check whether U.S. stocks are in an uptrend. If the return is positive (e.g., +10%), absolute momentum confirms that it’s safe to stay invested. If it were negative, absolute momentum would signal that it’s time to move into safer assets, even if U.S. stocks are the best-performing asset class compared to others.
The Power of Risk Management
A key strength of the Dual Momentum strategy is its ability to reduce risk. By avoiding underperforming markets through absolute momentum and staying invested in strong assets with relative momentum, the strategy helps investors minimize exposure to major market downturns while still capturing the benefits of bull markets.
Historical backtests of Dual Momentum, such as those presented by Gary Antonacci, show that the strategy has consistently outperformed traditional buy-and-hold approaches, particularly during periods of market stress like the 2008 financial crisis(Quantified Strategies)(QuantInvest).
Conclusion
By combining relative momentum (selecting the best-performing assets) with absolute momentum (staying in the market only when conditions are favorable), Dual Momentum provides a balanced and effective way to invest. This strategy offers the potential for higher returns with less risk, making it an attractive option for investors seeking to outperform the market while safeguarding their portfolios during downturns.
In the next article, we’ll explore how to choose the right asset classes and lookback periods to further optimize your Dual Momentum strategy. Stay tuned!