In physics, momentum is the tendency of a moving object to continue in its path. In finance, momentum investing is the exact same concept applied to prices. It is a system based on buying assets that have shown recent upward trends, and selling those that are declining.
While conventional wisdom says "buy low, sell high," momentum investors follow a different creed: "buy high, sell higher."
The Momentum Anomaly
In academic finance, Eugene Fama's Efficient Market Hypothesis (EMH) states that asset prices reflect all available information, making it impossible to consistently outperform the market. However, researchers discovered a glaring exception to this rule: the momentum anomaly.
First documented in detail by Narasimhan Jegadeesh and Sheridan Titman in 1993, data shows that assets which have outperformed their peers over the past 3 to 12 months tend to continue outperforming over the next 1 to 6 months.
Why Does Momentum Persist?
If momentum is such an obvious anomaly, why hasn't it been arbitrated away? The consensus points to behavioral psychology and investor biases:
- Underreaction: When good news is announced (e.g. strong corporate earnings), investors initially underreact. The price rises, but not immediately to its fair value, creating a slow-drifting upward trend.
- Herd Behavior / FOMO: As an asset continues to rise, more investors notice it, leading to Fear Of Missing Out. They buy in, pushing the price higher in a self-fulfilling loop.
- Disposition Effect: Investors tend to sell winners too early to lock in profits, while holding on to losers too long hoping to break even. This slows down the upward adjustment of winning stocks.
Relative vs. Absolute Momentum
It is critical to distinguish between the two primary momentum frameworks:
- Relative Momentum (Cross-Sectional): Compares assets against each other. For example, comparing Apple vs. Microsoft, or US stocks vs. Emerging Markets, and holding the strongest performer.
- Absolute Momentum (Time-Series / Trend Following): Compares an asset against its own past history or cash. For example, checking if the S&P 500 has a positive return over the last 12 months. If yes, buy; if no, sell and hold cash.
Summary: How to Use Momentum
Momentum investing is not without risk. It is susceptible to sudden trend reversals, known as "momentum crashes." To exploit the momentum factor safely, investors combine relative momentum with absolute momentum safety filters (as seen in the GEM or Dual Momentum strategies), allowing them to enjoy index outperformance while staying shielded during major market downturns.