When it comes to using strategies to guide your investment decisions, the pursuit of price momentum rates among the most successful and the most uncomfortable. Over the years, quant fund managers and academic researchers alike have espoused the virtues of momentum as a means of beating the market. However, since the 2009 market lows, sceptics have begun to question whether the momentum effect even exists any more.
Momentum investing really hit the headlines in 1993 when a seminal paper was published by US academics Jegadeesh and Titman, which showed that stocks that perform the best over a three- to 12-month period tend to continue to perform well over the subsequent three to 12 months. Likewise, the worst performers continue to perform badly. This observation triggered reams of further analysis, which narrowed down the momentum effect as something that specifically occurred between the second and eleventh month after the investment. Either side of that timeframe, the effect either didn’t work or went into reverse.
The general consensus in support of momentum claims the effect can be blamed on several factors, although the jury is still out on what these really are. One of the most popular suggestions is a type of behaviour known as the “disposition effect”, which relates to how both private and institutional investors react to news about a stock. The main point being that investors tend to sell too quickly on good news to lock-in profits while selling too slowly on bad news in the hope of eventually breaking even. In the words of US economist Toby Moskowitz, the effect:
“causes an artificial headwind: when good news is announced, the price of an asset does not immediately rise to its true value because of premature selling or a lack of buying. Similarly, when bad news is announced, the price falls less because investors are reluctant to sell.”
In other words, the disposition effect creates the environment that’s needed for momentum to occur in the subsequent months.
Highs and lows of momentum
One of the idiosyncrasies of momentum investing is that while the approach has been shown to work in bull and bear market conditions, the point at which markets turn can be seriously damaging to the strategy. To put this unnerving risk into context, Tom Hancock at investment firm GMO crunched the numbers in 2010…
