Momentum Factor

Momentum Factor

Investing based on market returns? Consider the Momentum Factor.

Why can't athletes stop as soon as they cross the finish line? Newton's first law of motion explains how the force used to reach the finish line becomes momentum and keeps them traveling in the same direction for a while even after the force is discontinued. A vector quantity, momentum includes both speed and direction.

This phenomena is fairly common in the stock market as well, when the movement of stocks develops momentum in reaction to a consistent force (buying or selling). Even after the initial impetus has diminished, this momentum keeps the stock price moving in the same direction. In other words, the momentum effect is the tendency for stocks that are already rising (or falling) to keep rising (or falling).

In factor investing, there are two momentum approaches. The first is time-series momentum, also known as absolute momentum, is estimated using a stock's own historical return. The second is cross-sectional or relative momentum which compares a stock's momentum to that of other stocks.

There are many choices regarding the time period for analyzing momentum. A single time period can be used or more than one time period to detect change in momentum.

Momentum Factor Work

The momentum factor has empirically generated positive excess returns,

As evidenced by several seminal works including the ones by Jegadeesh and Titman (Jegadeesh & Titman, 1993) and Carhart’s 4 Factor Model (Carhart, 1997).

A 2013 study by Professors Agarwalla, Jacob and Varma of the Indian Institute of Management, Ahmedabad (Agarwalla et al., 2013) calculated factor returns for the three Fama French factors and momentum for the Indian stock markets. Covering two decades of data, this study indicates that momentum was one of the strongest factors in India. This is in line with market experience as well which explains a dominant preference for momentum investing.

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