Momentum investing
Encyclopedia
Momentum investing, also sometimes known as "Fair Weather Investing", is a system of buying stock
s or other securities
that have had high returns over the past three to twelve months, and selling those that have had poor returns over the same period. It has been reported that this strategy yields
average returns of 1% per month for the following 3–12 months as shown by Narasimhan Jegadeesh and Sheridan Titman
.
While no consensus exists about the validity of this claim, economists have trouble reconciling this phenomenon, using the efficient-market hypothesis. Two main hypotheses have been submitted to explain the effect in terms of an efficient market. In the first, it is assumed that momentum investors bear significant risk
for assuming this strategy, and, therefore, the high returns are a compensation for the risk. The second theory assumes that momentum investors are exploiting behavioral shortcomings in other investors, such as investor herding, investor over and underreaction, and confirmation bias
.
Seasonal effects may help to explain some of the reason for success in the momentum investing strategy. If a stock has performed poorly for months leading up to the end of the year, investors may decide to sell their holdings for tax purposes. Increased supply of shares in the market drive its price down, causing others to sell. Once the reason for tax selling is eliminated, the stock's price tends to recover.
Some investors may react to the inefficient pricing of a stock caused by momentum investing by using the tool of arbitrage
.
It is believed that George Soros
used a variation of momentum investing by up bidding the price of already overvalued equities in the market for conglomerates
in the 1960s and for real estate investment trust
s in the 1970s. This strategy is termed positive feedback investing.
Richard Driehaus
is widely considered the father of momentum investing. This Chicago
money manager takes exception with the old stock market adage of buying low and selling high. According to him, "far more money is made buying high and selling at even higher prices."
Stock
The capital stock of a business entity represents the original capital paid into or invested in the business by its founders. It serves as a security for the creditors of a business since it cannot be withdrawn to the detriment of the creditors...
s or other securities
Security (finance)
A security is generally a fungible, negotiable financial instrument representing financial value. Securities are broadly categorized into:* debt securities ,* equity securities, e.g., common stocks; and,...
that have had high returns over the past three to twelve months, and selling those that have had poor returns over the same period. It has been reported that this strategy yields
Yield (finance)
In finance, the term yield describes the amount in cash that returns to the owners of a security. Normally it does not include the price variations, at the difference of the total return...
average returns of 1% per month for the following 3–12 months as shown by Narasimhan Jegadeesh and Sheridan Titman
Sheridan Titman
Sheridan Titman is a professor of finance at The University of Texas at Austin, where he holds the McAllister Centennial Chair in Financial Services at the McCombs School of Business, and is a research associate of the National Bureau of Economic Research. He holds a B.S. degree from the University...
.
While no consensus exists about the validity of this claim, economists have trouble reconciling this phenomenon, using the efficient-market hypothesis. Two main hypotheses have been submitted to explain the effect in terms of an efficient market. In the first, it is assumed that momentum investors bear significant risk
Financial risk
Financial risk an umbrella term for multiple types of risk associated with financing, including financial transactions that include company loans in risk of default. Risk is a term often used to imply downside risk, meaning the uncertainty of a return and the potential for financial loss...
for assuming this strategy, and, therefore, the high returns are a compensation for the risk. The second theory assumes that momentum investors are exploiting behavioral shortcomings in other investors, such as investor herding, investor over and underreaction, and confirmation bias
Confirmation bias
Confirmation bias is a tendency for people to favor information that confirms their preconceptions or hypotheses regardless of whether the information is true.David Perkins, a geneticist, coined the term "myside bias" referring to a preference for "my" side of an issue...
.
Seasonal effects may help to explain some of the reason for success in the momentum investing strategy. If a stock has performed poorly for months leading up to the end of the year, investors may decide to sell their holdings for tax purposes. Increased supply of shares in the market drive its price down, causing others to sell. Once the reason for tax selling is eliminated, the stock's price tends to recover.
Some investors may react to the inefficient pricing of a stock caused by momentum investing by using the tool of arbitrage
Arbitrage
In economics and finance, arbitrage is the practice of taking advantage of a price difference between two or more markets: striking a combination of matching deals that capitalize upon the imbalance, the profit being the difference between the market prices...
.
It is believed that George Soros
George Soros
George Soros is a Hungarian-American business magnate, investor, philosopher, and philanthropist. He is the chairman of Soros Fund Management. Soros supports progressive-liberal causes...
used a variation of momentum investing by up bidding the price of already overvalued equities in the market for conglomerates
Conglomerate (company)
A conglomerate is a combination of two or more corporations engaged in entirely different businesses that fall under one corporate structure , usually involving a parent company and several subsidiaries. Often, a conglomerate is a multi-industry company...
in the 1960s and for real estate investment trust
Real estate investment trust
A real estate investment trust or REIT is a tax designation for a corporate entity investing in real estate. The purpose of this designation is to reduce or eliminate corporate tax. In return, REITs are required to distribute 90% of their taxable income into the hands of investors...
s in the 1970s. This strategy is termed positive feedback investing.
Richard Driehaus
Richard Driehaus
Richard H. Driehaus is a fund manager, businessman and philanthropist. He is the founder and chairman of Driehaus Capital Management, based in Chicago, a firm which manages US$10 billion...
is widely considered the father of momentum investing. This Chicago
Chicago
Chicago is the largest city in the US state of Illinois. With nearly 2.7 million residents, it is the most populous city in the Midwestern United States and the third most populous in the US, after New York City and Los Angeles...
money manager takes exception with the old stock market adage of buying low and selling high. According to him, "far more money is made buying high and selling at even higher prices."
See also
- Momentum (finance)Momentum (finance)In finance, momentum is the empirically observed tendency for rising asset prices to rise further, and falling prices to keep falling. For instance, it was shown that stocks with strong past performance continue to outperform stocks with poor past performance in the next period with an average...
- Carhart four-factor model (1997) - extension of the Fama-French three-factor modelFama-French three-factor modelIn asset pricing and portfolio management the Fama-French three factor model is a model designed by Eugene Fama and Kenneth French to describe stock returns....
, containing an additional momentum factor (MOM)