The Momentum Strategy Explained
Understanding the Basics
The momentum strategy involves purchasing stocks that have performed well in the past and selling those that have underperformed. This approach challenges the notion of market efficiency, which suggests that all available information is already reflected in stock prices.
Evidence Supporting Momentum Investing
Research Findings
A seminal study by Jegadeesh and Titman in 1993 documented that momentum strategies can generate significant positive returns. Their research showed that these returns are not attributable to systematic risk or delayed reactions to common factors.
Short-Term Gains and Long-Term Reversals
The Pattern of Returns
Interestingly, while momentum strategies yield positive returns in the short term, these gains tend to partially dissipate in the following two years. This pattern suggests a potential overreaction in the market that eventually corrects itself.
Implications for Market Efficiency
Challenging the Efficient Market Hypothesis
The success of momentum strategies poses a challenge to the Efficient Market Hypothesis (EMH). If markets were truly efficient, such predictable patterns should not exist or should quickly disappear as investors exploit them.
Behavioral Explanations
Understanding Investor Psychology
Some researchers attribute the momentum effect to behavioral factors. Investors may underreact to new information initially, leading to a gradual price adjustment that creates the momentum effect.
Global Evidence
Momentum Across Markets
Subsequent research has shown that the momentum effect is not limited to the U.S. stock market but is observable in international markets as well. This global presence further strengthens the case for momentum as a significant market phenomenon.
Practical Applications
Implementing Momentum Strategies
Investors can potentially leverage momentum strategies by focusing on stocks that have shown strong recent performance. However, it’s crucial to consider transaction costs and potential risks associated with this approach.
Limitations and Considerations
Potential Drawbacks
While momentum strategies have shown historical success, they are not without risks. Market conditions can change, and past performance does not guarantee future results. Additionally, transaction costs and taxes can erode potential gains.
The Future of Momentum Investing
Evolving Strategies
As markets evolve and become more efficient, the effectiveness of simple momentum strategies may diminish. Investors and researchers continue to refine these approaches, incorporating additional factors to enhance their performance.
