In Brief

An investing strategy of buying prior winning stocks and selling short prior losers based on the empirical observation that Investments exhibit persistence in their relative performance. As George Chestnutt wrote back in 1965: “Which is the best policy?  To buy a strong stock that is leading the advance or to "shop around" for a "sleeper" or "behind-the-market" stock in the hope that it will catch up?  . … Many more times than not, it is better to buy the  leaders and leave the laggards alone.  In the market, as in many other  phases of life, "the strong get stronger, and the weak get weaker."

Background

Buying winners inherently con?icts with the contrarian philosophy that is part and parcel of many successful investors. Nevertheless, it has long been noted by traders that good performing investments tend to continue to do so, whereas those that have performed relatively poorly tend to continue on the same path.

Momentum investing is not to be confused with growth investing, short-term price acceleration, or general trend following. It usually involves a disciplined, systematic investing style based on relative price strength over a specific (usually 6 to 12 months) formation period combined with systematic entry and exit rules. 

Definition of a Relative Strength Screen

Richard Driehaus is an example of an investor with a heavy momentum bias, blending earnings and price momentum. However, an indicative 'pure momentum' screen might be: 

  • Exclude the most illiquid stocks, e.g. the bottom 25% of stocks based on market capitalisation
  • High relative strength in the last six months compared with the market (top 25%) - relative strength doesn't work over short timeframes, such as one month.
  • High relative strength in the previous twelve months compared with the market (top 25%), with the 12 months being higher than the three months
  • The hold period for investments would typically also be in the 3-12 month range.

Adding value and/or earnings momentum criteria usually increases the screen effectiveness (see below).

Interestingly, this study  showed that individual investors tend to be relatively bad at applying momentum investing strategies effectively, as against professional investors.

How Well Does it Work?

Academics have focused on studying momentum investing properly for the better part of two decades. A study by Hancock found a momentum strategy outperformed a broad universe of U.S. stocks by nearly 4% per year from 1927-2009.

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