Does Momentum Investing Work?
While it runs counter to the principles of market efficiency, momentum can offer a powerful way to improve diversification and enhance expected returns.
You should be skeptical of anyone who claims to be able to predict the future from the past. If it were so easy to beat the market using past returns, everyone would exploit that relationship until it is arbitraged away. The momentum effect violates that principle. Momentum is based on the premise that securities that have recently outperformed will continue to do so in the short run, and those that have underperformed will continue to lag. While practitioners have been exploiting this relationship for decades, the idea has gained broad acceptance in the academic community only within the past 20 years. Momentum runs counter to the predictions of the efficient market hypothesis, but the evidence is too overwhelming to ignore.
Jegadeesh and Titman published one of the first influential studies on momentum in 1993, “Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency.” They found that U.S. stocks with the best performance over the past three-12 months continued to outperform the worst-performing stocks over the next year, using data from 1965 to 1989. Subsequent research found that the momentum effect was also present in the U.S. before and after this original sample, which suggests that the effect was not simply the product of data mining. Generally any momentum signal between six and 12 months worked, though there tends to be a short-term reversal at one month. It has become convention among many researchers to study the momentum effect using stock returns over a trailing 12-month period, excluding the most recent month. However, the results are robust and do not depend on this particular definition.
Alex Bryan does not own shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.
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