Understanding momentum investing: risks, strategies, and new insightsMomentum investing, characterized by high returns but also significant drawdowns, has intrigued investors for decades. The strategy involves capitalizing on the trend of stocks that have recently performed well continuing to outperform, and vice versa. However, historical data since 1926 reveals a rollercoaster ride of high returns punctuated by sharp downturns, with several notable crashes like those in 1932 and 2001.The research indicates that while momentum can yield monthly returns as high as 1.15%, it also exhibits a kurtosis of 16.6 and negative skewness of -2.3. These statistics highlight the risk of extreme negative returns during certain periods. Notably, crashes are often triggered by large gains of previous losers during market reversals.Researchers like Pedro Barroso and Pedro Santa-Clara have delved into managing this risk. Their 2015 study revealed that momentum's risk is variable and predictable over time, with volatility increasing during crashes. By managing this volatility through scaling, crash risk can be virtually eliminated while significantly improving the Sharpe ratio of the momentum strategy.Kent Daniel and Tobias Moskowitz further refined this approach by developing a dynamic momentum strategy based on forecasts of momentum mean and variance. This dynamic approach demonstrated a remarkable increase in alpha and Sharpe ratio compared to static strategies.Other researchers like Dion Bongaerts, Xiaowei Kang, and Mathijs van Dijk explored conditional volatility targeting, which adjusts risk exposures based on extreme volatility states. This strategy significantly reduces drawdowns and tail risks while also lowering turnover.Recent research by Lionel Smoler-Schatz emphasized the role of high-yield spreads in predicting momentum returns. Tight spreads correlate with robust momentum premia, whereas elevated spreads predict weaker returns. Smoler-Schatz's work suggests that a spread exceeding 700 basis points can signal a reversal in momentum strategies.For investors, the takeaway is clear. Momentum investing offers significant returns but comes with substantial risks, particularly during market reversals. Incorporating systematic risk management strategies, such as volatility scaling and spread analysis, can help mitigate these risks and enhance overall performance.I'm currently exploring these various strategies and systems through the AlgoTrading Mastery: Strategy & Systems course here on Limex. In this course, we are learning how to intelligently and profitably navigate momentum investing, all backed by empirical research and advanced insights. So if you're also interested, check it out, it's completely free. Invest with knowledge, manage risks effectively, and harness the power of momentum investing for long-term success.