Back in 1993 Jegadeesh and Titman presented their monumental paper called Returns to buying winners and selling losers: implications for stock market efficiency. It was published in the Journal Of Finance and is one of the most cited research in finance ever. It’s now 30 years since it was published. What is the momentum trading strategy? Does the momentum strategy still work?
Related reading:
What Is The Momentum Trading Strategy?
We quote the abstract from the paper:
This paper documents that strategies which buy stocks that have performed well in the past and sell stocks that have performed poorly in the past generate significant positive returns over 3- to 12-month holding periods. We find that the profitability of these strategies are not due to their systematic risk or to delayed stock price reactions to common factors. However, part of the abnormal returns generated in the first year after portfolio formation dissipates in the following two years. A similar pattern of returns around the earnings announcements of past winners and losers is also documented.
In other words, stocks that have performed the best over the last 1-12 months, perform the best in the next 1-12 months. Winners continue to be winners (over the short term) and losers ten to be losers (in the short term).
This phenomenon, known as momentum, has had a significant impact on both the investment and academic worlds.
For investors, momentum presents a robust, viable, and profitable investment or trading strategy that has been widely adopted by active mutual funds, hedge funds, and passive ETFs. For financial researchers, momentum poses a striking challenge to the weak form efficient market hypothesis of Fama (which was presented in 1970).
The momentum trading strategy in simpler terms
Put short, this is momentum investing:
Momentum investing is a strategy that involves buying stocks that have been rising in price and selling stocks that have been falling in price. The idea is that stocks that have been going up are likely to continue going up, and stocks that have been going down are likely to continue going down.
Momentum investing has been shown to be a profitable strategy, and it is used by many professional investors.
Here is an example of how momentum investing might work:
Suppose you are considering investing in a stock. You look at the stock’s price chart and see that it has been rising steadily for the past few months. This is a good sign, according to momentum investing theory. It suggests that the stock is likely to continue going up in the future.
You buy the stock and hold it for a few more months. The stock continues to rise, and you make a profit. You then sell the stock and move on to the next investment opportunity.
However, to make it work you need to be very systematic. You can’t pick just random stocks, you need to make baskets of stocks. It’s a quantitative strategy and not a discretionary strategy.
Explanations for momentum – why is there momentum?
Let’s look at some explanations from the paper about why momentum exists:
Behavioral explanations
Behavioral models of momentum investing try to explain why stock prices tend to continue moving in the same direction for a while. These models are based on the idea that investors are not always rational and that they make mistakes.
Three common mistakes that investors make are:
- They react too slowly to new information.
- They overreact to new information.
- They are more likely to sell stocks that have lost money and hold on to stocks that have made money.
These mistakes can lead to momentum, which is when stocks that have been rising in price continue to rise, and stocks that have been falling in price continue to fall.
Behavioral models of momentum investing can be used to develop investment strategies. For example, investors can buy stocks that have been rising in price and sell stocks that have been falling in price. However, it is important to note that these strategies are not guaranteed to be profitable.
Does the momentum trading strategy still work?
In a new study by Tobias Wiest called Momentum: what do we know 30 years after Jegadeesh and Titman’s seminal paper? the author looked at the 30 years that have gone since the original report was published. Has it held up well in out-of-sample?
We quote from the paper:
To summarize, momentum was one of the most prominent topics in financial research over the last three decades, and recent findings on the commonality in momentum effects present fruitful grounds for future prominence.
In simpler terms: Yes, in the 30 years since the momentum trading strategy was invented, it has worked well in many countries and industries.
