Momentum and trend following
Securities that recently did well kept outperforming on average over the following months. The effect is well documented, but comes with sharp drawdowns and weakens once it becomes known.
Momentum's basic idea is about as simple as it gets: securities that rose more than average over the last three to twelve months keep rising more than average, on average, over the following months. And the reverse: whatever recently performed weakly tends to keep performing weakly.
This is one of the most thoroughly studied patterns in all of finance research. Economists Narasimhan Jegadeesh and Sheridan Titman showed in 1993 that a strategy buying recent strong stocks and short-selling recent weak ones earned a clear excess return over their study period. The finding has since been replicated in most stock markets worldwide and in other asset classes.
A related but different variant is trend following, where what counts isn't the comparison between securities, but a single market's own price direction. A study by AQR Capital Management found positive results for trend-following strategies across stocks, bonds, commodities, and currencies in nearly every decade since 1880.
The effect has an unpleasant flip side. Momentum strategies occasionally suffer very sharp, brief drawdowns, for instance when a market abruptly reverses after a crisis. Hold the trend too long against an already-occurring reversal, and you can lose a substantial share of years of accumulated excess return within a few weeks.
Jegadeesh and Titman (1993) documented that a strategy buying past winners and shorting past losers over three- to twelve-month holding periods earned a monthly excess return on the order of about one percent. The authors showed in a 2001 follow-up study that this excess return didn't vanish in the years after the initial publication, arguing against pure data-snooping as an explanation.
Two camps face off in explaining the effect. Behavioral-finance explanations trace it to investors' delayed reactions to new information, followed by positive feedback from trend followers. Risk-based explanations argue that past winners carry higher systematic risk than past losers. Cooper, Gutierrez, and Hameed (2004) and Daniel and Moskowitz (2016) show that the excess return depends heavily on recent market conditions and can turn negative during recovery phases after crises, a pattern called momentum crash risk.
For trend following across entire market segments, Hurst, Ooi, and Pedersen (2017, AQR) provide a study across 67 markets and over a hundred years, with consistently positive results and low correlation to traditional asset classes. Important for context: both effects are measured in academic studies after accounting for realistic but simplified trading costs. Jegadeesh and Titman's 2001 study also found a later reversal of the excess return over two to five years after the holding period ended, suggesting a long-term overreaction that later unwinds.
Summary
- Recently strong securities kept outperforming on average over the following months.
- The effect is documented across decades and many markets, but not risk-free.
- Momentum strategies occasionally suffer sharp drawdowns, especially during recovery phases after crises.
Did you get it?
What did Jegadeesh and Titman show in 1993?
That a strategy buying past winners and selling past losers earned a clear excess return over three to twelve months.
What is a momentum crash?
A sharp, brief drawdown of momentum strategies, typically occurring during recovery phases after market crises.
Which two camps face off in explaining the momentum effect?
Behavioral explanations citing delayed reactions and feedback, and risk-based explanations citing higher systematic risk in past winners.
Sources and further reading
- Jegadeesh, N. and Titman, S. (1993), Returns to Buying Winners and Selling Losers, Journal of Finance
- Jegadeesh, N. and Titman, S. (2001), Profitability of Momentum Strategies, Journal of Finance View source ↗
- Hurst, B., Ooi, Y. H. and Pedersen, L. H. (2017), A Century of Evidence on Trend-Following Investing, AQR Capital Management View source ↗
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