Momentum (Finance)

Momentum, in finance, is the tendency of assets that have performed well in the recent past to keep performing well in the near future, and of those that have performed poorly to keep performing poorly. It also names the investment style that seeks to profit from this by buying recent winners and selling recent losers. The effect has been documented in shares, bonds, currencies and commodities and across many countries and decades.

Momentum is one of the best-known challenges to the efficient market hypothesis, since it implies that past prices help predict future returns. It is treated as a standard factor in factor investing, alongside value, size and others. It is distinct from the physical concept of the same name, and from the momentum oscillators of technical analysis, though all share the idea of a move that persists.

The usual measure for a share is its return over the past twelve months, leaving out the most recent month:

• $P_{t-1}$ is the price one month ago.
• $P_{t-12}$ is the price twelve months ago.

A share that traded at 80 a year ago and at 100 a month ago has a momentum of $100 / 80 - 1 = 25$ percent. The latest month is skipped because, over very short horizons, returns tend to reverse, an effect called short-term reversal. Prices are adjusted for dividends and splits so that the figure reflects the return to a holder.

Cross-sectional momentum ranks assets against each other. In the classic design, shares are sorted each month by past return, the top tenth are bought and the bottom tenth are sold short, and the positions are held for several months. The result depends on relative performance, so the portfolio can be long and short in equal amounts whatever the market has done.

Time-series momentum looks at each asset on its own: an asset is bought if its own past return is positive and sold if it is negative. This is the logic of trend following, practised mainly in futures markets by managed futures funds. The two forms are related but can behave differently, since in a broad market fall a time-series strategy may be short almost everything.

The modern literature dates from a 1993 study by Narasimhan Jegadeesh and Sheridan Titman, who found that US shares with the highest returns over the previous three to twelve months outperformed those with the lowest by about one percent a month over the following three to twelve months. Later studies found the same pattern in most other equity markets, in earlier historical periods and in other asset classes. In 1997 Mark Carhart added a momentum factor to the three-factor model of Fama and French, and it has been a standard component of a factor model of returns since. Momentum profits tend to reverse over horizons of three to five years, which links the effect to long-run mean reversion.

• Underreaction. Investors adjust too slowly to news, so prices drift towards their new level instead of jumping. The post-earnings announcement drift is a related pattern.
• Overreaction and herding. Rising prices attract further buying from investors who extrapolate, pushing prices beyond fair value until they eventually correct. These accounts come from behavioral finance.
• Risk. Some researchers argue that winners are riskier in ways standard models miss, so the returns are compensation for risk, not a sign of mispricing. The strategy's occasional severe losses give this view some support.
• Limits to arbitrage. Trading costs, restrictions on short selling and the career risk of fund managers prevent the pattern from being fully traded away.

Momentum has delivered positive average returns with a distribution that is sharply skewed to the downside. Long periods of steady gains have been interrupted by sudden, deep losses, most often when markets rebound after a steep decline and the beaten-down shares held short rally hardest. Such an episode is called a momentum crash.

The strategy also trades heavily. Rankings change every month, and the shares with the most extreme past returns are often small and illiquid, so the transaction cost of keeping the portfolio up to date absorbs a significant part of the paper profit, particularly on the short side. Studies that account for costs find lower, though in many cases still positive, returns for large and liquid shares. Returns to well-known factors have also tended to weaken after publication as more capital pursues them.

Institutional investors rarely run momentum alone. It is commonly combined with value, because the two have tended to do well at different times, a pairing discussed under value and momentum strategy. Index providers publish momentum indices, and funds track them. Technical traders apply the same idea through rules such as the moving average crossover. The shorter-term, discretionary version is covered under momentum trading.