Why Momentum Investing Works ?
Momentum investing is counter-intuitive to almost every other strategy out there, which can make investors uncomfortable if they don’t know what they’re doing.
For a value investor, the value anomaly is easy to explain — buy at a discount and then wait. The momentum factor is based on buy high, sell higher or alternatively, cut your losses and let your winners run.
Value investing is based on a long-term reversion to the mean. Momentum investing is based on that gap in time that exists before mean reversion occurs. Value is a long game, while momentum is usually seen in the short- to intermediate-term.
Investors are constantly being told that it’s a huge mistake to chase performance. And it is a terrible idea to chase performance if you don’t know what you’re doing or why you’re doing it. Momentum is chasing performance, but in a systematic way, with an entry and exit strategy in place.
Momentum tries to take advantage of performance chasers who are making emotional decisions. This is why the best momentum investors use a rules-based approach, to avoid those emotions.
So what exactly is momentum? In short, momentum is the fact that markets tend to continue to trend in the direction they’re going much longer than most people assume is possible.
Investments that have performed well tend to continue to perform well and investments that have performed poorly tend to continue to perform poorly.
Eugene Fama and Ken French, the fathers of the efficient market hypothesis, had this to say about momentum:
The premier market anomaly is momentum. Stocks with low returns over the past year tend to have low returns for the next few months, and stocks with high past returns tend to have high future returns.
Research shows that investors hold onto losing stocks too long in hopes they will come back to their original price while selling their winners too early. Investors also anchor to recent results, so initially markets underreact to news, events or data releases.
On the flip side, once things become apparent, investors herd and overreact, causing an overshoot in either direction. Fear, greed, overconfidence and the confirmation bias can lead investors to pile into winning areas of the market after they’ve risen or pile out after they’ve fallen.
Basically, momentum tries to benefit from irrational market participants. This can be easier said than done as these trends don’t last forever and can have swift reversals when they do come to an end after they overshoot.