Momentum

Momentum, in the investment world, is the fascinating—and often perplexing—tendency for winning stocks to keep winning and for losing stocks to keep losing. It’s a strategy built on the simple idea that an object in motion stays in motion. A momentum investor isn't trying to find a hidden gem selling for 50 cents on the dollar; instead, they're looking for the stock that everyone is talking about, the one that’s been rocketing up the charts, and they're jumping on for the ride. This approach is a prominent example of factor investing, where strategies are built around specific characteristics, or “factors,” that have historically driven returns. Unlike value investing, which focuses on a company's intrinsic worth, momentum is all about price trends. The core belief is that recent performance (typically over the last 3 to 12 months) is a good predictor of future performance in the short term. It’s a strategy that plays on market psychology and the often-slow reaction of investors to new information.

While it might sound like simply chasing fads, there's a surprising amount of academic evidence supporting momentum. The “why” it works is often attributed to human behavior rather than cold, hard fundamentals.

Momentum exists because markets aren't always perfectly efficient. It's fueled by a cocktail of behavioral biases that affect us all:

• Underreaction: Investors can be slowpokes. When a company releases surprisingly good news, its stock price might drift upwards for months as the information slowly spreads and gets fully priced in by the market.
• Herding: Nobody likes to miss a party. As a stock rises, it attracts more attention, leading more investors to pile in, pushing the price even higher. This creates a self-fulfilling prophecy, at least for a while.
• Confirmation Bias: We love to be right. Investors who own a winning stock will actively look for information that confirms their brilliant decision, while ignoring negative news. This can keep the stock's upward trajectory going longer than it should.

A pure momentum strategy is systematic and unemotional. While there are many variations, a classic approach looks like this:

1. Rank: Take a broad universe of stocks (like the S&P 500) and rank them based on their price performance over a “look-back” period, such as the last 12 months. Interestingly, most strategies ignore the most recent month's performance, as it can be prone to short-term noise and reversals.
2. Go Long: Buy a portfolio of the top-performing stocks (e.g., the top 10% or 20%). These are the “winners.”
3. Go Short: For a more aggressive strategy, an investor might simultaneously engage in short selling the worst-performing stocks (e.g., the bottom 10% or 20%). These are the “losers.”
4. Rebalance: Hold this portfolio for a set “holding period,” typically one to three months, and then repeat the entire process. This constant reshuffling is a key feature of the strategy.

For disciples of Warren Buffett and Benjamin Graham, momentum can feel like a dirty word. Value investing is about patiently buying good businesses at cheap prices, while momentum is about buying popular stocks at high—and rising—prices.

Value investing is fundamentally contrarian. The goal is to take advantage of Mr. Market's pessimism, buying what is unloved and undervalued. A value investor’s favorite stock is often one that has performed terribly, creating a bargain. A momentum investor, by contrast, would be selling that exact same stock. As Buffett famously said, “The stock market is a device for transferring money from the impatient to the patient.” Momentum strategies, with their frequent trading, are the essence of impatience.

Surprisingly, yes. Some of the most sophisticated investors, like Clifford Asness of AQR Capital Management, have shown that these two seemingly opposite forces can work together beautifully. The idea is to find stocks that are both:

• Cheap: Possessing attractive value characteristics (e.g., a low P/B ratio or high dividend yield).
• On the Move: Exhibiting strong recent price momentum.

This combination can be powerful. It helps an investor buy a cheap stock right as the rest of the market is starting to recognize its value, potentially avoiding the dreaded “value trap“—a stock that is cheap for a reason and just keeps getting cheaper.

Before you rush off to buy last year's high-flyers, it's critical to understand the serious risks involved.

Momentum works until, suddenly, it doesn't. The strategy is prone to rare but severe meltdowns, known as “momentum crashes.” These often occur at major market turning points. When a bubble bursts (like the dot-com bubble in 2000) or a crisis bottoms out (like the 2008 financial crisis in early 2009), market leadership can change in a heartbeat. The previous “winners” become the new “losers” almost overnight, causing devastating losses for a momentum portfolio.

Perhaps the biggest practical hurdle for an ordinary investor is the cost. Because momentum strategies require frequent rebalancing, they generate very high turnover. This leads to two major drags on performance:

• Transaction Costs: Constant buying and selling racks up brokerage fees and bid-ask spread costs, which can significantly eat into your profits.
• Taxes: In a taxable account, this high turnover generates a stream of short-term capital gains, which in the US and many European countries are taxed at a much higher rate than the long-term gains favored by value investors.

For these reasons, a pure momentum strategy is often difficult for individual investors to implement successfully after accounting for all real-world frictions.