What Is Momentum Strategy?
A momentum strategy is an investment strategy that seeks to capitalize on the tendency of existing trends in asset prices to continue. Within the broader field of investment strategies, it operates on the principle that securities that have performed well in the past (winners) will continue to perform well, and those that have performed poorly (losers) will continue to perform poorly. This approach forms a core component of many portfolio management techniques, aiming to generate returns by riding these persistent price trends. The momentum strategy often involves buying assets that have shown upward price movement and selling assets that have shown downward price movement over a defined period.
History and Origin
The concept of price momentum has been observed in financial markets for centuries, but its formal academic recognition and study gained significant traction in the late 20th century. One of the most influential papers documenting the efficacy of momentum as a financial anomaly was published in 1993 by Narasimhan Jegadeesh and Sheridan Titman. Their research, titled "Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency," provided empirical evidence that strategies buying past winners and selling past losers generated significant positive returns over three- to twelve-month holding periods. This seminal work challenged aspects of the Efficient Market Hypothesis, which posits that asset prices fully reflect all available information, making it impossible to consistently earn abnormal returns. The findings by Jegadeesh and Titman helped solidify momentum's place as a distinct and widely researched factor in quantitative finance.6
Key Takeaways
- A momentum strategy identifies and invests in assets that have demonstrated recent strong performance, expecting that performance to continue.
- It is based on the idea that market trends, once established, tend to persist for a period.
- Momentum investing can be applied across various asset classes, including equities, bonds, commodities, and currencies.
- While historically effective, a momentum strategy is subject to market reversals and periods of underperformance.
- It often complements other diversification and risk management techniques.
Formula and Calculation
The core of a momentum strategy involves calculating the past performance of an asset. While there's no single universal formula, a common method for determining an asset's momentum is to calculate its relative strength over a look-back period.
One common calculation for momentum, often referred to as "price momentum," uses the following formula:
Where:
- (P_{current}) = The current price of the asset.
- (P_{lookback}) = The price of the asset at the beginning of the look-back period.
A positive momentum value indicates that the asset's price has increased over the look-back period, while a negative value indicates a decrease. The look-back period can vary, commonly ranging from 3 to 12 months, excluding the most recent month to avoid short-term reversals.
Interpreting the Momentum Strategy
Interpreting a momentum strategy involves identifying assets exhibiting strong price trends and understanding the implications for asset allocation. A high positive momentum score suggests an asset has been a "winner" and is a candidate for inclusion in a momentum-driven portfolio, based on the expectation of continued upward movement. Conversely, a low or negative momentum score indicates an asset is a "loser" and might be a candidate for selling or shorting.
The effectiveness of a momentum strategy is often attributed to human psychological biases, falling under the umbrella of behavioral finance. Investors may under-react to new information, causing prices to drift gradually in one direction, or they may herd, pushing prices beyond their fundamental value. Recognizing these patterns is key to applying momentum principles, but it's crucial to acknowledge that market trends can reverse.
Hypothetical Example
Consider an investor implementing a 6-month momentum strategy for a portfolio of stocks. They analyze three hypothetical stocks:
- Stock A: Started at $50, now $60.
- Stock B: Started at $100, now $95.
- Stock C: Started at $20, now $28.
Calculations:
- Stock A Momentum: (\frac{$60}{$50} - 1 = 0.20) or 20%
- Stock B Momentum: (\frac{$95}{$100} - 1 = -0.05) or -5%
- Stock C Momentum: (\frac{$28}{$20} - 1 = 0.40) or 40%
Based on these calculations, Stock C has the highest positive momentum, followed by Stock A. Stock B has negative momentum. A momentum strategy would suggest buying or increasing holdings in Stock C and Stock A, while potentially selling or avoiding Stock B. The investor would then re-evaluate these positions periodically, for instance, every three or six months, to adjust the portfolio based on ongoing price movements. This approach aims to capture persistent trends in the stock market.
Practical Applications
A momentum strategy finds broad application in the financial world, particularly in quantitative trading and systematic investment approaches. Portfolio managers utilize momentum to construct portfolios of "winning" stocks or other assets, often rebalancing regularly to maintain exposure to the strongest performers. It can be integrated into broader investment frameworks as a "factor" alongside other characteristics like value, size, or quality.
Beyond individual stock picking, momentum can be applied at the sector or even country level. For instance, an investor might rotate into sectors that are currently outperforming the broader market. Market observers also frequently discuss the pervasive nature of market momentum, influencing overall market direction and investor sentiment. In recent market cycles, particularly after periods of significant economic or technological shifts, strong market momentum has been noted in various sectors and indices.5,4 Economic research, such as that provided by the Federal Reserve Bank of San Francisco, often analyzes market dynamics and investor behavior which can indirectly relate to the forces driving momentum.3
Limitations and Criticisms
Despite its historical effectiveness, a momentum strategy is not without its limitations and criticisms. One significant drawback is its susceptibility to sudden market reversals, often referred to as "momentum crashes." These occur when previously strong trends abruptly reverse course, leading to significant losses for momentum-oriented portfolios. Such crashes can be particularly pronounced during periods of high market uncertainty or economic shocks.2
Critics also point out that momentum profits may be partially explained by beta (systematic risk) or other forms of risk not fully captured by traditional asset pricing models. Furthermore, transaction costs from frequent buying and selling, inherent to many momentum strategies, can significantly erode potential profits, especially in less liquid markets. The phenomenon is also often seen as a reflection of market inefficiency, suggesting that investors are either slow to incorporate new information or overreact to past performance. This can lead to periods where the strategy underperforms significantly, challenging its long-term viability for all market conditions.
Momentum Strategy vs. Contrarian Strategy
The momentum strategy and the contrarian strategy represent two opposing philosophies in investing. A momentum strategy involves buying assets that have performed well recently ("winners") and selling assets that have performed poorly ("losers"), operating on the belief that existing trends will continue. In contrast, a contrarian strategy involves buying assets that have performed poorly ("losers") and selling assets that have performed well ("winners"), based on the expectation that asset prices will eventually revert to their mean or fundamental value.
| Feature | Momentum Strategy | Contrarian Strategy |
|---|---|---|
| Core Principle | Price trends persist | Prices revert to the mean |
| Action | Buy high, sell low (relative to recent performance) | Buy low, sell high (relative to recent performance) |
| Investor View | Market under/over-reaction leads to trend continuation | Market overreaction leads to eventual correction |
| Typical Horizon | Short-to-medium term | Medium-to-long term |
| Risk | Vulnerable to trend reversals and crashes | Can suffer prolonged periods of underperformance |
Confusion between the two often arises because both strategies are based on analyzing past price movements, but they interpret and act on that information in fundamentally opposite ways. Momentum capitalizes on continuation, while contrarianism profits from reversal.
FAQs
What drives the momentum phenomenon in markets?
The momentum phenomenon is believed to be driven by a combination of factors. These include investor behavioral biases such as under-reaction to new information, which causes prices to drift slowly, and overreaction or herding behavior, which can push prices beyond their intrinsic value.1 Technical factors, such as the buying and selling pressure from large institutional investors, can also contribute to the persistence of trends.
Can a momentum strategy be used by individual investors?
Yes, individual investors can implement a momentum strategy, though it may require consistent monitoring and rebalancing. Simple approaches involve selecting exchange-traded funds (ETFs) or mutual funds that track sectors or asset classes with strong recent performance. Utilizing tools that rank assets by technical analysis indicators like relative strength can also assist in identifying momentum candidates. However, transaction costs and taxes from frequent trading should be considered.
Is momentum strategy always profitable?
No, a momentum strategy is not always profitable. While it has demonstrated historical effectiveness across various markets and asset classes, it is prone to periods of significant drawdowns, particularly during sharp market reversals or shifts in market regimes. No investment strategy guarantees profits, and momentum is no exception. It is one of many factors considered in professional portfolio management.
How does momentum relate to market efficiency?
The existence of a profitable momentum strategy challenges the strong and semi-strong forms of the Efficient Market Hypothesis. If markets were perfectly efficient, past price movements should not predict future returns. The profitability of momentum suggests that market prices do not instantaneously or fully reflect all available information, allowing for short-to-medium-term predictability in asset returns, thus representing a financial anomaly.
What is the optimal look-back period for momentum?
There is no single optimal look-back period for a momentum strategy, as it can vary depending on the market, asset class, and prevailing economic conditions. Common look-back periods range from 3 to 12 months, often excluding the most recent month to avoid short-term reversals. Researchers and practitioners often test different look-back and holding periods to find what works best for specific applications.