Why Momentum Strategies Work

Earlier this week, Simon Moore, Chief Investment Officer at Moola, wrote a great piece in Forbes on Momentum and how it is implemented as a portfolio strategy. The concept of Momentum is something I have studied quite a bit, and am a believer in myself. Things that go up, tend to keep going up, and things that are going down tend to keep going down. It’s a simple concept at a base level (Newton’s 1st Law), but it can also be tough for the human brain to take advantage of this theory in real life.

Why is it so hard for most humans to believe that extreme trends can continue? Because it doesn’t really feel like a practical application. But it is. Have you ever heard someone say XYZ stock “just can’t keep going up/down”? I know I have been a victim of this in the past. But in reality, those stocks tend to keep their trend for the foreseeable future.

Here’s a great example from 2004:

Apple stock gained over 200% in 2004, a monumental year. After those types of returns, most investors would pat themselves on the back, take their profits, and put the capital to work somewhere else. And this is a very practical mindset to have. However, Apple gained another 123% in 2005. 2006? 18%. 2007? 133%. Had you sold at the end of 2004, you missed out on another 513% of gains over the next three years. While this may be an extreme example, I think the point is pretty clear.

Momentum doesn’t simply work on an absolute basis, meaning the investment has risen in value. It also works on a relative basis, in that the investment typically outperforms the broad market as well. Further, Simon brings to our attention how Robert Novy-Marx incorporates this phenomenon into his own work. Novy-Marx suggests that the best predictor of momentum is intermediate past performance. He finds that how a stock did in the previous 6-12 months is the optimal predictor of its momentum. Thus, even if a stock has fallen recently, if the previous two quarters have seen strong returns, then the overall momentum of the stock is still intact.

I personally believe there are a few human biases that come into play when discussing Momentum as an investing strategy, namely the disposition effect and herding. Wes Gray does a great job of discussing the two in his piece from 2013. Essentially, the disposition effect is the tendency of investors to sell their profitable positions and keep their losing positions, in hope that the losers will eventually turn around. Further, and the concept that I think supplies the most support for Momentum, is the concept of herding, more commonly referred to as FOMO (“fear of missing out”). A stock goes up. Way up. You hear about it on TV. You hear about it at Christmas dinner from your nephew. Heck, even the babysitter is talking about. You have to get in, right? This is one of the main reasons that big gains and new highs beget more gains and more new highs. Everyone wants to be a part of it.

Momentum is among the strongest factors that managers can incorporate into their portfolios. There’s no denying that it has worked for over many timeframes and in many different environments. While the drawdowns can be hard to stomach, the long(er) term effects are quite valuable. For more on momentum from The Chart Report read this post.