Why are runners unable to stop right after crossing the finish line?
The force that is applied to move them towards the finish line builds momentum and keeps them moving in the same direction for some time even after, which is explained by Newton’s first law of motion. Momentum is a vector quantity, which means that it contains both speed and direction.
This phenomenon is quite prevalent in the stock market as well with the motion of stocks in response to a force (buying or selling) building momentum if it is sustained for some time. This momentum doesn’t stop when the original force wanes but continues to push the stock price in the same direction for some time. In other words, the momentum effect is the propensity of already rising (or falling) securities to continue rising (or falling) largely due to the cycle of fear, greed, and hope inherent in the investment decision making.
According to the efficient market hypothesis (EMH) the Momentum Premium cannot exist. But momentum effects are pervasive in financial markets. In fact, it is so pervasive that even the Nobel Laureate Eugene Fama, the creator of the EMH, famously said that momentum is “the premier market anomaly”*.
*An anomaly is a phenomenon that cannot be explained with theories and that defies rational markets.
Prevalence of irrationalities and behavioural biases such as optimism/pessimism, confirmation bias, representativeness, and herding further boost momentum effect in the markets. Although juxtaposed against popular contrarian strategies such as value investing, momentum has been empirically proven to generate abnormal incremental returns. However, momentum is more of a short-term phenomenon and its return-enhancing effect reduces sharply with time. As a result, using momentum may require frequent rebalancing with the associated increase in portfolio turnover and transaction costs.
There are two momentum approaches in factor investing. These are,
- Time-series momentum: Sometimes referred to as absolute momentum, time-series momentum is calculated based on a stocks own past return, considered independently from the returns of the other stocks.
- Cross-sectional momentum: Originally referred to as relative strength, before academics developed a more jargon-like term, cross-sectional momentum is a measure of a stock’s performance relative to other stocks.
Within these two as well, there are many choices to be made with regard to the time period for evaluating momentum, whether to use more than one time period to ascertain change in momentum etc. Each has its own benefits and sacrifices which make this choice a crucial one in crafting a stock selection methodology.