Momentum Investing: It Works, But Why?

From the time we entered the stockmarket, all of us have been taught that “if everyone knows that the stock is a BUY then that info is fully factored in the stock price and you can’t make money”. But if that is the case then how is that “momentum investing – which is betting that the stock market’s recent winners will remain winners in the near term and, likewise, that the recent losers will remain losers” – works.

In 1993 a pioneering study published in the Journal of Finance by Narasimhan Jegadeesh and Sheridan Titman, both at UCLA Anderson at the time, showed that “buying recent stock winners and selling recent losers generated significantly higher near-term returns than the U.S. market overall from 1965 to 1989.” However, Jegadeesh & Titman did not explain in that piece why momentum investing works

UCLA Anderson’s Avanidhar Subrahmanyam has had a crack at laying out some of the reasons why momentum investing works in his August 2018 paper for the Pacific-Basin Finance Journal.

“In his research into 25 years of academic literature on momentum, Subrahmanyam found that many of the rationales presented for the strategy’s success fall into one of two behavioral categories: Investors either overreact to important information, or they underreact to it. Because, after all, we’re only human.”

For example, we underreact to momentum because some stocks rise slowly & gradually. At a psychological level, it appears that our brain does not lock-into these winners early enough and discount the entire upside that can accrue in the future. Another example of a psychological bias which could cause momentum is if a stock has been doing well in our portfolio, we become wedded to it and fail to discount bad news on the company efficiently (our brain does not place a high enough emphasis on the bad news).

Leaving aside psychology, another reason momentum investing might be so successful is risk premia i.e. the upside we get from momentum investing is the return we get from buying a risky stock.

All of this being said, even Subrahmanyam concludes that the consistent & puzzling success of momentum investing is perhaps the greatest challenge to Eugene Fama’s “efficient markets” theory.

To read, Subrahmanyam’s fascinating paper, click here:
http://www.anderson.ucla.edu/Documents/sites/faculty/review%20publications/research/Subra2018_Momentum.pdf