Momentum

What Is Momentum?

Momentum, within the realm of investment strategy, refers to the observed tendency for assets that have performed well in the recent past to continue to perform well, and for assets that have performed poorly to continue to perform poorly. This persistence in performance is a key concept in quantitative finance and is often categorized under the broader field of behavioral finance due to its proposed origins in investor behavior. Momentum strategies aim to capitalize on this phenomenon by buying securities with strong recent price trends and selling those with weak ones. The concept of momentum challenges some tenets of the efficient market hypothesis, which suggests that all available information is already reflected in asset prices.

History and Origin

The concept of momentum has been observed in financial markets for centuries, but its modern academic recognition largely stems from the 1993 seminal paper by Narasimhan Jegadeesh and Sheridan Titman, titled "Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency."¹¹ Their research empirically demonstrated that strategies involving buying past winning stocks and selling past losing stocks generated significant positive returns over three- to twelve-month holding periods.¹⁰ This groundbreaking work provided a robust statistical foundation for the momentum anomaly, spurring extensive further research and the development of systematic momentum-based portfolio management strategies. Academics and practitioners alike have since explored momentum's pervasive nature across various asset classes and global markets.⁹

Key Takeaways

• Momentum is the tendency of past winning investments to continue to outperform and past losing investments to continue to underperform.
• It is a widely recognized anomaly in financial markets, frequently attributed to behavioral biases like under-reaction and herd mentality.
• Momentum strategies typically involve ranking securities based on their recent price performance and then investing in those with the strongest trends.
• While historically profitable, momentum strategies can experience periods of significant underperformance, particularly during sharp market reversals.
• Implementing momentum requires careful consideration of transaction costs and portfolio turnover.

Formula and Calculation

Momentum is typically quantified for individual securities based on their cumulative returns over a specific look-back period. A common approach for calculating a security's momentum score involves looking at its performance over the past 3 to 12 months, often excluding the most recent month to mitigate short-term reversal effects.

The cumulative return (Momentum Score, (MS)) for a given period can be expressed as:

Where:

• (MS) = Momentum Score for the security
• (R_t) = Monthly return of the security in month (t)
• (N) = Number of months in the look-back period (e.g., 11 months, excluding the most recent month).

This calculation allows for the ranking of securities based on their past price trajectory, forming the basis for constructing momentum portfolios.

Interpreting Momentum

Interpreting momentum involves understanding that it is a relative concept: it refers to an asset's performance relative to its peers or the broader stock market over a defined period. A high momentum score indicates that an asset has significantly outperformed others, while a low or negative score suggests underperformance. Investors often use momentum as an indicator to identify securities that are currently in favor, riding the "trend" in prices.

The strength and persistence of momentum can vary across different timeframes and market cycles. For instance, an asset might show strong short-term momentum but weak long-term momentum, or vice-versa. Understanding this distinction is crucial for applying momentum as an investment strategy. The underlying behavioral explanations for momentum often point to investor biases such as delayed reaction to new information and a "herding" effect, where investors follow the actions of others, perpetuating initial price movements.⁸

Hypothetical Example

Consider two hypothetical stocks, Stock A and Stock B, over the past 11 months.

• Stock A: Started at $100.

  • Month 1: +5% (to $105)
  • Month 2: +3% (to $108.15)
  • ... (consistent positive returns)
  • Month 11: Final price $140.
  • Cumulative return = ($140 - $100) / $100 = 40%

• Stock B: Started at $100.

  • Month 1: -2% (to $98)
  • Month 2: -1% (to $97.02)
  • ... (consistent negative or flat returns)
  • Month 11: Final price $90.
  • Cumulative return = ($90 - $100) / $100 = -10%

In this example, Stock A exhibits strong positive momentum with a 40% cumulative return over the period, while Stock B shows negative momentum with a -10% return. A momentum-based investment strategy might suggest buying Stock A and avoiding or shorting Stock B, based on the expectation that their recent trends will continue. This approach contrasts with traditional fundamental analysis, which focuses on intrinsic value.

Practical Applications

Momentum is a widely employed factor in modern quantitative investment strategy and is integrated into various portfolio management approaches. Its applications include:

• Factor Investing: Momentum is recognized as a persistent factor alongside others like value, size, and quality, used by institutional investors and quantitative funds to construct diversified portfolios. Firms like AQR Capital Management have dedicated significant research and practical implementation to momentum strategies.⁷
• Exchange-Traded Funds (ETFs): A growing number of ETFs are designed specifically to track momentum indices, providing retail and institutional investors with easy access to momentum-based exposures without needing to directly manage individual securities.⁶
• Tactical Asset Allocation: Investors may use momentum signals to tactically shift allocations between different asset classes (e.g., rotating from equities to bonds or commodities) based on their relative performance trends.
• Stock Selection: Momentum serves as a key criterion in rules-based stock screening processes, helping to identify securities that have recently outperformed the broader stock market and are expected to continue doing so. This is distinct from technical analysis, which primarily uses charts and patterns.

Limitations and Criticisms

While momentum has been a historically robust anomaly, it is not without its limitations and criticisms. A primary concern is its susceptibility to sharp reversals, often referred to as "momentum crashes." These occur when previously strong trends suddenly reverse, leading to significant losses for momentum portfolios.⁵ Such crashes can be particularly severe, challenging the profitability of the strategy over certain periods.⁴

Another criticism is that momentum strategies typically involve high turnover, as portfolios are frequently rebalanced to capture changing trends. This frequent trading can lead to higher transaction costs and potential tax inefficiencies, which can erode actual risk-adjusted returns.³ Additionally, some academics argue that momentum profits may be partially explained by variations in systematic risk or limits to arbitrage, suggesting that the anomaly persists because it is difficult or costly for investors to exploit.² Momentum strategies also face the inherent risk of "chasing past performance," as there is no guarantee that past trends will continue into the future.¹

Momentum vs. Value Investing

Momentum and value investing represent two fundamentally different approaches to identifying investment opportunities, often viewed as contrasting styles within investment strategy.

While seemingly opposite, some investors combine elements of both momentum and value strategies to potentially enhance diversification and improve risk-adjusted returns, recognizing that different market environments may favor one style over the other.

FAQs

What is the "momentum effect" in finance?

The momentum effect refers to the empirical observation that assets with strong past performance tend to continue performing well, and assets with weak past performance tend to continue performing poorly, over certain look-back and holding periods. It's considered an anomaly because it suggests a deviation from perfectly efficient market hypothesis.

Is momentum investing a short-term or long-term strategy?

Momentum strategies are typically considered medium-term, with look-back and holding periods often ranging from 3 to 12 months. While the underlying phenomenon has shown persistence over extended periods, the active nature of continually identifying and rotating into new "winners" makes it more active than a traditional long-term buy-and-hold investment strategy.

How does market volatility affect momentum strategies?

Volatility can significantly impact momentum strategies. During periods of high market volatility or sharp market reversals, momentum strategies can experience sudden and significant drawdowns as past trends quickly dissipate or reverse. Conversely, during sustained trending markets, momentum can perform strongly.

Can individual investors use momentum strategies?

Yes, individual investors can implement momentum strategies, either directly by researching and selecting securities based on past returns, or indirectly through investing in momentum-focused Exchange-Traded Funds (ETFs) or mutual funds. However, the high turnover and potential for large drawdowns require careful consideration and understanding of the risks involved.