One of the core advantages of the Dual Momentum investing strategy is its built-in risk management feature, which helps protect investors from significant market downturns. By combining relative momentum (comparing assets against each other) and absolute momentum (evaluating an asset’s trend against a risk-free benchmark), dual momentum not only seeks higher returns but also prioritizes reducing risk. In this article, we will explore how the dual momentum strategy manages risk and discuss ways to optimize it for your portfolio.
Why Risk Management Matters in Investing
Before diving into the mechanics of risk management in dual momentum, it’s important to understand why managing risk is crucial for long-term investment success. Markets are inherently unpredictable, and large drawdowns during crises can wipe out years of gains. Effective risk management allows you to:
- Reduce exposure to severe market declines.
- Preserve capital during times of uncertainty.
- Maintain a steady path toward long-term growth.
By mitigating large losses, you ensure that your portfolio doesn’t need to make extraordinary gains just to recover from setbacks.
How Dual Momentum Manages Risk
Dual momentum incorporates two layers of risk management: relative momentum and absolute momentum. Here’s how each plays a role in reducing risk:
1. Relative Momentum: Identifying Strong Performers
Relative momentum compares the performance of different asset classes, such as U.S. stocks, international stocks, and bonds. By investing in the top-performing asset class over a set period (usually 6-12 months), relative momentum ensures you’re investing in assets that are gaining strength relative to others.
Risk Benefit: This method reduces the risk of holding underperforming assets. For example, if U.S. stocks are declining while bonds are rallying, relative momentum would shift your allocation from stocks to bonds, helping avoid losses in declining markets.
2. Absolute Momentum: Protecting Against Market Crashes
Absolute momentum serves as a protective mechanism by comparing the performance of an asset class against a risk-free benchmark, such as short-term Treasury bills or cash. If the asset class underperforms this benchmark (i.e., it has negative absolute returns), the strategy shifts your portfolio to safer assets like bonds or cash.
Risk Benefit: Absolute momentum prevents you from being fully exposed to risky assets during broad market crashes. For instance, during the 2008 financial crisis or the COVID-19 pandemic crash, absolute momentum would have moved your portfolio out of equities and into bonds or cash, protecting you from significant losses.
Optimizing Risk Management in Dual Momentum
While dual momentum inherently manages risk, there are additional ways you can optimize the strategy for your portfolio, enhancing its risk-reward profile.
1. Adjusting Lookback Periods
The length of the lookback period (the time window you use to calculate momentum) can significantly impact your risk exposure. Shorter lookback periods (e.g., 3-6 months) are more responsive to market changes but may result in more frequent trades and higher transaction costs. Longer lookback periods (e.g., 12 months) are more stable but may delay signals during volatile markets.
Optimization Tip: If you’re seeking higher risk management and lower volatility, consider using a slightly longer lookback period (e.g., 12 months) for both relative and absolute momentum. This can help you avoid whipsawing in and out of positions during short-term market fluctuations.
2. Diversifying Across Asset Classes
While dual momentum traditionally focuses on major asset classes like stocks and bonds, adding more diversified asset classes can reduce risk further. For example, you could include:
- Commodities: These can act as a hedge against inflation and economic uncertainty.
- Real Estate Investment Trusts (REITs): These offer exposure to real estate markets, which often behave differently from equities.
- Gold: As a traditional safe haven, gold can provide protection during times of market turmoil.
Optimization Tip: Adding more asset classes increases diversification, giving you a broader range of assets to choose from when markets are volatile.
3. Incorporating Risk-Adjusted Momentum
Another way to enhance dual momentum’s risk management is by incorporating risk-adjusted momentum. Instead of simply focusing on raw returns, you can adjust your calculations to account for volatility (using metrics like Sharpe ratio). This allows you to prioritize assets that offer a better return for the level of risk they carry.
Optimization Tip: Use tools like TradingView or AllocateSmartly to create custom momentum indicators that incorporate volatility measures. This can help you avoid high-risk assets, even if they have strong recent performance.
4. Setting Dynamic Cash Buffers
During extreme market conditions, it may be wise to allocate more of your portfolio to cash. While dual momentum naturally shifts to safer assets like bonds during downturns, you can further reduce risk by setting a dynamic cash buffer—a portion of your portfolio that automatically moves into cash when markets exhibit extreme volatility.
Optimization Tip: Use technical indicators like volatility indexes (VIX) or moving averages to trigger dynamic cash allocations during periods of heightened uncertainty.
Case Study: Dual Momentum During the 2008 Financial Crisis
To understand how dual momentum’s risk management works in practice, let’s revisit one of the most extreme market events in recent history—the 2008 financial crisis.
- Relative Momentum: In 2007, relative momentum would have favored bonds over stocks, as the bond market began to outperform equities leading up to the crisis.
- Absolute Momentum: As the S&P 500 entered freefall in late 2007 and early 2008, absolute momentum would have signaled to exit stocks entirely, moving the portfolio into bonds or cash.
- Outcome: Dual momentum investors avoided the catastrophic 50%+ drawdowns that buy-and-hold investors suffered. By shifting to safer assets, the strategy protected capital during the worst of the crisis and positioned investors to re-enter the market as it began to recover in 2009.
Conclusion: Enhancing Dual Momentum with Better Risk Management
Risk management is at the heart of the dual momentum strategy. By combining the power of relative and absolute momentum, investors can navigate market volatility while capturing growth in rising markets. However, the strategy is not one-size-fits-all, and there are numerous ways to optimize it for your specific risk tolerance and financial goals.
Whether you adjust lookback periods, diversify your asset classes, or incorporate risk-adjusted momentum, optimizing the risk management aspect of dual momentum can improve your portfolio’s resilience in the face of market downturns.
Stay tuned for more in-depth strategies on risk management and optimization in dual momentum, as well as real-world examples of how this powerful investing strategy can protect your capital while delivering long-term growth.