What Is Momentum Strategies?
Momentum strategies are an investment approach within the broader category of quantitative finance that seeks to capitalize on the tendency of assets that have performed well recently to continue performing well, and conversely, those that have performed poorly to continue underperforming. This core principle suggests that "the trend is your friend" and can persist for a period28. Momentum investing is a widely recognized market anomaly in behavioral finance, challenging the strong form of the efficient market hypothesis, which posits that all available information is immediately reflected in asset prices27. Momentum strategies are systematic and disciplined, relying on objective data rather than subjective forecasts26.
History and Origin
The concept of momentum in financial markets has been observed for centuries, but its systematic study and formal recognition as an investment strategy are more recent. The seminal academic paper "Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency," published in 1993 by Narasimhan Jegadeesh and Sheridan Titman, is widely credited with providing robust empirical evidence for the existence of momentum in stock returns24, 25. Their research demonstrated that portfolios of past winning stocks continued to outperform past losing stocks over various short- to medium-term horizons. This finding sparked significant interest among academics and practitioners, leading to extensive further research into the causes and applications of the momentum effect. Subsequent studies confirmed that momentum profits were not limited to U.S. markets but were also observed in other international markets and across different asset classes22, 23.
Key Takeaways
- Momentum strategies aim to profit from the persistence of asset price trends.
- They involve buying assets that have recently performed well ("winners") and selling assets that have performed poorly ("losers").
- Momentum is considered a market anomaly, suggesting that markets are not perfectly efficient.
- The strategy relies on quantitative analysis of historical price movements.
- While potentially profitable, momentum strategies are subject to various risks and limitations.
Formula and Calculation
Momentum is typically calculated by looking at an asset's total return over a specific look-back period, often ranging from 3 to 12 months, excluding the most recent month to avoid short-term reversals.
A common way to calculate the momentum score for an individual asset is:
Where:
- Current Price = The most recent closing price of the asset.
- Price N Months Ago = The closing price of the asset N months prior to the current date.
For instance, if using a 12-month look-back with a 1-month lag, "Price N Months Ago" would be the price 13 months ago. This calculation provides the percentage change in price over the chosen period. Investors then rank assets based on these momentum scores to identify potential "winners" and "losers" for their portfolios. This often involves comparing an asset's total return against a benchmark or other assets within its asset class.
Interpreting the Momentum
Interpreting momentum involves identifying assets that exhibit strong positive or negative trends in their prices over a defined period. A high positive momentum score indicates that an asset has significantly outperformed in the recent past, suggesting a potential continuation of that trend. Conversely, a low or negative momentum score points to recent underperformance, which might persist.
Investors apply momentum by establishing long positions in high-momentum assets and, in some cases, short positions in low-momentum assets. The strength and consistency of the trend are key factors. For example, a stock that has steadily risen for nine consecutive months might be considered to have stronger momentum than one with a more volatile, but ultimately positive, return over the same period. This interpretation guides portfolio allocation decisions, emphasizing a systematic approach to identifying and acting on price trends. The goal is to capture further gains from trending assets.
Hypothetical Example
Consider two hypothetical stocks, Company A and Company B, at the end of December.
- Company A: Its price was $50 on January 1st and is now $65.
- Company B: Its price was $100 on January 1st and is now $90.
To calculate their 12-month momentum (excluding the most recent month for simplicity in this example, but typically using a 1-month lag in practice):
For Company A:
Momentum Score = ($65 - $50) / $50 = $15 / $50 = 0.30 or 30%
For Company B:
Momentum Score = ($90 - $100) / $100 = -$10 / $100 = -0.10 or -10%
In this scenario, Company A exhibits positive momentum of 30%, indicating it has been a "winner" over the past year. Company B shows negative momentum of -10%, classifying it as a "loser." A momentum strategy might suggest buying Company A and potentially selling or shorting Company B. This approach is a form of active management, seeking to outperform a passive investment strategy.
Practical Applications
Momentum strategies are employed across various financial markets, including equities, commodities, and currencies. In equity markets, investors and fund managers use momentum to select stocks that have recently shown strong price appreciation, aiming to ride the continuation of that trend21. This can involve constructing portfolios of "winner" stocks or employing long-short strategies that simultaneously buy winners and sell losers.
Beyond individual stocks, momentum is applied in factor investing, where momentum is recognized as a specific factor (or characteristic) that can explain differences in asset returns. Investment firms, such as Research Affiliates, explore the role of momentum in equity portfolios and in multi-factor strategies19, 20. The strategy can also be applied to broader market indices, exchange-traded funds (ETFs), or even sectors, by allocating capital to areas showing relative strength. For example, a shift in market momentum could indicate a rotation from European equities to U.S. equities, influencing asset allocation decisions18. Furthermore, academic research continues to investigate momentum in various asset classes, including the U.S. Treasury market, suggesting its broad applicability in identifying persistent trends17.
Limitations and Criticisms
Despite its empirical support, momentum strategies face several limitations and criticisms. One significant challenge is their vulnerability to sudden market reversals, often referred to as "momentum crashes"16. These crashes can occur when previously strong trends abruptly reverse, leading to substantial losses for momentum-oriented portfolios. Such events can erase significant accumulated gains, highlighting the importance of a robust risk management framework.
Another key criticism revolves around trading costs. Momentum strategies typically involve frequent buying and selling of assets (high turnover), which can lead to considerable transaction expenses that erode profits14, 15. The profitability of momentum strategies can be significantly impacted by these costs, especially for smaller-capitalization stocks or less liquid assets13. Some research suggests that while simulated momentum portfolios show strong returns, live results for mutual funds employing momentum strategies have been surprisingly weak, partly due to these implementation costs12.
Furthermore, the theoretical explanations for momentum are still debated within financial economics. While some theories point to behavioral biases such as investor underreaction or overreaction to new information, or herding behavior, others suggest it might be compensation for risk not captured by traditional asset pricing models10, 11. The debate continues regarding whether momentum is a true market anomaly or merely a reflection of underlying risks or data mining. The impact of market structure changes and the increasing visibility of monetary policy have also been explored as factors influencing market anomalies, including momentum8, 9.
Momentum Strategies vs. Value Investing
Momentum strategies and value investing represent distinct, often contrasting, approaches to portfolio management. Momentum focuses on recent price trends, buying "winners" and selling "losers," under the assumption that past performance will continue. It is a trend-following strategy that emphasizes relative price strength.
In contrast, value investing seeks to identify assets whose market price is below their intrinsic value. Value investors look for "bargains"—companies that may be temporarily out of favor or undervalued by the market, believing their prices will eventually revert to their true worth. This approach often involves fundamental analysis of a company's financial health, assets, and earnings, rather than just price movements.
The confusion between the two arises because both are popular investment styles aiming to generate alpha (excess returns). However, their underlying philosophies are fundamentally different: momentum rides trends, while value seeks to exploit mispricings. In certain market conditions, momentum and value strategies can be negatively correlated, meaning one may outperform when the other underperforms, offering potential diversification benefits if combined within a single investment portfolio. Research Affiliates, for instance, has explored how to combine value and momentum, acknowledging their complementary nature.
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FAQs
What causes the momentum effect in financial markets?
The momentum effect is often attributed to behavioral biases among investors, such as slow reaction to new information, investor herding, and overconfidence, leading to under- and overreactions in asset prices. 5, 6Some theories also suggest it might be a compensation for risk.
Can momentum strategies work in all market conditions?
No, momentum strategies tend to perform well in trending markets (upward or downward) but can struggle in choppy, sideways, or rapidly reversing markets. They are particularly vulnerable to sudden "momentum crashes".
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Is momentum investing suitable for long-term investors?
Momentum strategies typically involve higher turnover and are generally considered short-to-medium-term trading strategies. Long-term investors often favor approaches like buy-and-hold or dollar-cost averaging. However, some long-term factor-based approaches may incorporate momentum as one of several factors.
How do trading costs affect momentum strategy profitability?
Trading costs can significantly reduce the profitability of momentum strategies due to their high turnover. Frequent buying and selling of assets incur commissions, bid-ask spreads, and other expenses that can erode gross returns.
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Is there a specific look-back period that works best for momentum?
While academic research often points to 3- to 12-month look-back periods (excluding the most recent month), the "best" period can vary depending on the asset class and market conditions. Investors may experiment with different look-back and holding periods to optimize their approach. There is no universally optimal period, and research continues to explore optimal timeframes.
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LINK_POOL
- quantitative finance
- behavioral finance
- efficient market hypothesis
- percentage change
- total return
- benchmark
- asset class
- portfolio allocation
- active management
- passive investment
- factor investing
- equity portfolio
- asset allocation
- risk management
- trading costs
- financial economics
- asset pricing models
- value investing
- alpha
- diversification benefits
- investment portfolio
- buy-and-hold
- dollar-cost averaging