Momentum investing is a system of buying
stock
In finance, stock (also capital stock) consists of all the shares by which ownership of a corporation or company is divided.Longman Business English Dictionary: "stock - ''especially AmE'' one of the shares into which ownership of a company ...
s or other
securities
A security is a tradable financial asset. The term commonly refers to any form of financial instrument, but its legal definition varies by jurisdiction. In some countries and languages people commonly use the term "security" to refer to any for ...
that have had high returns over the past three to twelve months, and selling those that have had poor returns over the same period.
While momentum investing is well-established as a phenomenon no consensus exists about the explanation for this strategy, and economists have trouble reconciling momentum with the
efficient market hypothesis
The efficient-market hypothesis (EMH) is a hypothesis in financial economics that states that asset prices reflect all available information. A direct implication is that it is impossible to "beat the market" consistently on a risk-adjusted bas ...
and
random walk hypothesis. Two main hypotheses have been submitted to explain the momentum effect in terms of an efficient market. In the first, it is assumed that momentum investors bear significant
risk
In simple terms, risk is the possibility of something bad happening. Risk involves uncertainty about the effects/implications of an activity with respect to something that humans value (such as health, well-being, wealth, property or the environme ...
for assuming this strategy, and, therefore, the high returns are a compensation for the risk. Momentum strategies often involve disproportionately trading in stocks with high bid-ask spreads and so it is important to take transactions costs into account when evaluating momentum profitability. The second theory assumes that momentum investors are exploiting behavioral shortcomings in other investors, such as
investor herding, investor over- and underreaction,
disposition effect
The disposition effect is an anomaly discovered in behavioral finance. It relates to the tendency of investors to sell assets that have increased in value, while keeping assets that have dropped in value.
Hersh Shefrin and Meir Statman identified ...
s and
confirmation bias
Confirmation bias is the tendency to search for, interpret, favor, and recall information in a way that confirms or supports one's prior beliefs or values. People display this bias when they select information that supports their views, ignoring ...
.
Seasonal or
calendar effect
A calendar effect (or calendar anomaly) is any market anomaly, different behaviour of stock markets, or economic effect which appears to be related to the calendar, such as the day of the week, time of the month, time of the year, time within the ...
s may help to explain some of the reason for success in the momentum investing strategy. If a stock has performed poorly for months leading up to the end of the year, investors may decide to sell their holdings for tax purposes causing for example the
January effect
The January effect is a hypothesis that there is a seasonality, seasonal market anomaly, anomaly in the financial market where security (finance), securities' prices increase in the month of January more than in any other month. This calendar effec ...
. Increased supply of shares in the market drive its price down, causing others to sell. Once the reason for tax selling is eliminated, the stock's price tends to recover.
History
Researchers have identified persistent momentum trends in stock markets as far back as the
Victorian Era
In the history of the United Kingdom and the British Empire, the Victorian era was the period of Queen Victoria's reign, from 20 June 1837 until her death on 22 January 1901. The era followed the Georgian period and preceded the Edwardia ...
(ca. 1830s to 1900).
[Chabot, Benjamin Remy and Ghysels, Eric and Jagannathan, Ravi, Momentum Trading, Return Chasing, and Predictable Crashes (November 2014). CEPR Discussion Paper No. DP10234, Available at SSRN: https://ssrn.com/abstract=2521455] Richard Driehaus
Richard Herman Driehaus (; July 28, 1942 – March 9, 2021) was an American fund manager, businessman and philanthropist. He was the founder, chief investment officer, and chairman of Driehaus Capital Management LLC, based in Chicago.
The philant ...
(1942-2021) is sometimes considered the father of momentum investing but the strategy can be traced back before Donchian. The strategy takes exception with the old stock market adage of
buying low and selling high
In finance, a long Position (finance), position in a financial instrument means the holder of the position owns a positive amount of the instrument. The holder of the position has the expectation that the financial instrument will increase in valu ...
. According to Driehaus, "far more money is made buying high and selling at even higher prices."
In the late 2000s, as computer and networking speeds increase each year, there were many sub-variants of momentum investing being deployed in the markets by computer driven models. Some of these operate on a very small time scale, such as
high-frequency trading
High-frequency trading (HFT) is a type of algorithmic financial trading characterized by high speeds, high turnover rates, and high order-to-trade ratios that leverages high-frequency financial data and electronic trading tools. While there is no ...
, which often execute dozens or even hundreds of trades per second.
Although this is a reemergence of an investing style that was prevalent in the 1990s,
ETFs for this style began trading in 2015.
Performance of momentum strategies
In a study in 1993 Narasimhan Jegadeesh and
Sheridan Titman
Sheridan Dean Titman is a professor of finance at the University of Texas at Austin, where he holds the McAllister Centennial Chair in Financial Services at the McCombs School of Business. He received a B.S. degree (1975) from the University of C ...
reported that this strategy give average returns of 1% per month for the following 3–12 months. This finding has been confirmed by many other academic studies, some even going back to the 19th century, though momentum strategies are associated with an increased risk of crashes and major losses.
[
Turnover tend to be high for momentum strategies, which could reduce the net returns of a momentum strategy. Some even claim that transaction costs wipe out momentum profits. In their 2014 study 'fact, fiction, and momentum investing' ]Cliff Asness
Clifford Scott Asness (; born October 17, 1966) is an American hedge fund manager and the co-founder of AQR Capital Management.
Early life and early education
Asness was born to a Jewish family, in Queens, New York, the son of Carol, who ran a ...
and his co-authors address 10 issues with regards to momentum investing, including transaction costs.
The performance of momentum comes with occasional large crashes. For example, in 2009, momentum experienced a crash of -73.42% in three months. This downside risk of momentum can be reduced with a so called 'residual momentum' strategy in which only the stock specific part of momentum is used.
A momentum strategy can also be applied across industries and across markets.
Explanation
In capital market theory, the momentum factor is one of the most well-known market anomalies. In studies, it has been observed that securities that have risen in recent months tend to continue to do so for a few more months. Depending on which past period was taken as a reference and how long the securities were held thereafter, a different magnitude of effect was observed. The same applies in reverse for securities that have recently fallen in value. One explanation is the so-called post-earnings announcement drift, which assumes that investors initially do not fully price in the higher enterprise value after the announcement of better-than-expected earnings figures. The share price only rises gradually with a delay until the true higher value is only reached after a few months.
Since past price information hereby provides information about future developments and a profitable strategy can be generated from it, the momentum factor is in contradiction to the weak market efficiency. So-called momentum crash
In Newtonian mechanics, momentum (more specifically linear momentum or translational momentum) is the product of the mass and velocity of an object. It is a vector quantity, possessing a magnitude and a direction. If is an object's mass and ...
es, which usually occur in recovery phases after financial market crashes, are considered to be a risk-based explanation. Most alternative explanations come from behavioral finance
Behavioral economics studies the effects of psychological, cognitive, emotional, cultural and social factors on the decisions of individuals or institutions, such as how those decisions vary from those implied by classical economic theory.
...
.
See also
* Behavioral economics
Behavioral economics studies the effects of psychological, cognitive, emotional, cultural and social factors on the decisions of individuals or institutions, such as how those decisions vary from those implied by classical economic theory. ...
* Carhart four-factor model
In portfolio management, the Carhart four-factor model is an extra factor addition in the Fama–French three-factor model, proposed by Mark Carhart. The Fama-French model, developed in the 1990, argued most stock market returns are explained ...
*Low-volatility investing Low-volatility investing is an investment style that buys stocks or securities with low volatility and avoids those with high volatility. This investment style exploits the low-volatility anomaly. According to financial theory risk and return shou ...
* Market anomaly
A market anomaly in a financial market is predictability that seems to be inconsistent with (typically risk-based) theories of asset prices. Standard theories include the capital asset pricing model and the Fama–French three-factor model, Fama-F ...
* Momentum (finance)
In finance, momentum is the empirically observed tendency for rising asset prices or securities return to rise further, and falling prices to keep falling. For instance, it was shown that stocks with strong past performance continue to outperform ...
*Trend following
Trend following or trend trading is a trading strategy according to which one should buy an asset when its price trend goes up, and sell when its trend goes down, expecting price movements to continue.
There are a number of different techniques, ...
*Value investing
Value investing is an investment paradigm that involves buying securities that appear underpriced by some form of fundamental analysis. The various forms of value investing derive from the investment philosophy first taught by Benjamin Graham ...
* Post-Earnings-Announcement-Drift
References
Further reading
* Soros, George, 1987, ''The Alchemy of Finance'', Simon and Schuster, New York.
* Tanous, Peter J., 1997, ''Investment Gurus'', New York Institute of Finance
The New York Institute of Finance (NYIF) is an American Education Company that was founded by the New York Stock Exchange (NYSE) in 1922.
The institute provides continuing education to professionals in the finance Industry and corporations worldw ...
, NJ, .
* Antonacci, Gary, 2014, ''Dual Momentum Investing: An Innovative Approach for Higher Returns with Lower Risk,'' McGraw-Hill Education, New York,
The Definitive Guide To Momentum Investing and Trading
Signal Plot, August 24, 2017
* Hageback, Niklas, 2014, ''The Mystery of Market Movements: An Archetypal Approach to Investment Forecasting and Modelling,'' Bloomberg,
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