TOP fund managers such as Fidelity’s Anthony Bolton and Neil Woodford of Invesco Perpetual champion contrarian investment, but a new study has found that the opposite strategy can make you big money.

Both managers advocate a policy of buying stocks they feel are underpriced and holding them for long periods. However, the London Business School report suggests that so-called momentum investing – buying top-per-forming stocks and selling those at the bottom of the pile on a monthly basis – has made 15.2% a year over the past century, compared with 9.4% if you had simply followed the market. So £1 invested in 1900 would now be worth £4.2m.

Over 50 years, annual returns are higher at 18.3%, compared with 13.2% for the market, turning £1 into £6,208.

Elroy Dimson, who wrote the report with colleagues Paul Marsh and Mike Staunton, said: “We felt this approach was an intriguing area because research looking at US markets over limited periods showed that it provided striking returns. We wanted to see whether this would extend to global markets over a longer timescale.”

The strategy works because it capitalises on the herd mentality. When a sector performs well, it often continues to do so as other investors do not want to lose out rather than because of the underlying fundamental outlook – hence the term momentum.

The tobacco sector, for example, developed its own momentum following the technology crash in 2000, despite smoking bans around the world, and leapt 960% in 2000-7, according to the report.

The sector left new industries such as computer software – down 88% – and mobile telecoms – off 62% – for dust. Other winners included the mining sector, which jumped 667%, and personal goods companies, up 521%.

These figures support the approach of renowned trader Warren Buffett, who avoids new industries because he believes it is near impossible to pick out the survivors among the many companies jostling for market share.

Justin Urquhart Stewart of Seven Investment Management said: “A contrarian investor would buy stocks when they look weak. So investors following this type of strategy would probably think financial-services companies look a good bet now.

“Momentum investors, though, would be selling financial-services firms in the belief that they will continue to fall.”

So, can following the herd really boost your returns? Quite simply, momentum trading involves buying past winners and short-selling past losers in the hope of purchasing them again at a lower price.

Dimson and his team tested momentum investing using data on the UK’s 100 largest listed firms since 1900. After creating two portfolios, one with the 20 top-performing equities in the previous 12 months and the other the 20 worst performers, they recalculated the make-up of each on a monthly basis.

If you had bought the losers, however, they would have returned just 4.5% a year. So an investor picking these stocks would have turned their £1 initial investment into just £111 by the end of 2007.

Dimson and his colleagues found this pattern repeated across the developed world’s stock markets in the 20th century. And the UK figures are even more arresting when based on portfolios of the 10 top and worst-performing stocks – though the risk profile of the investments also rises.

It is easy to identify the best and worst performers over the past 12 months using websites such as Digitallook and Advfn.

On Friday, the past year’s top performers in the FTSE All-Share were the miners Randgold Resources and Rio Tinto, up 110% and 98% respectively. Online auctioneer Tradus was up 101%.

The worst performers, which you would short, include computer games firm SCI Entertainment, which has dropped 92%, mortgage company Paragon, down 89%, telecoms firm Vanco, off 82%, and fund manager New Star Asset Management, which has fallen 77%.

Investors can short stocks using spread bets or contracts for difference (CFDs).

Replicating the report’s hypothetical portfolios would involve a high turnover of shares, resulting in huge transaction costs that would have slashed the above returns by more than 50%.

It requires a huge amount of discipline, though, as you have to change your holdings each month to reflect performance. It still works if you turn over your portfolio less often, but usually less successfully.

Change your winners and losers every three months and you end up with roughly the same result, the research suggests. But after three months the returns from the strategy start to trail off. The approach also has long periods in the doldrums.

A new breed of “intelligent” exchange traded fund (ETF) could offer a cheap way to follow market trends. As yet none has been created that follows the momentum strategy.

However, a range of ETFs have been launched based on different styles of investing, meaning you can switch between funds as conditions change.

Barclays Global Investors, for example, offers some ETFs linked to the Dow Jones Euro Stoxx index. This includes a Euro Stoxx Growth iShare focusing on fast-growing companies.

When shares are struggling a value approach, based on companies whose shares look cheap, is often more profitable. At times like that you want to be in the Euro Stoxx Value fund.

MAINTAIN YOUR MOMENTUM

- Buy stocks with the best form and short sell those languishing.

- Be disciplined. Trade shares each month to ensure that you always hold the top 20% of the market and short the bottom 20%.

- Find ways to cut trading costs. The price of buying and selling shares could cut your returns over the 100-year period by more than 50%. Use low-cost trading platforms such as Sharenetwork.

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