EC Momentum Investing — A Path To Wealth?

 

recent article showed how a simple moving average (SMA) could be employed as a screen to signal when you should be in or out of the market. It proved superior to a buy-and-hold strategy when applied to a mutual fund that represented the total US stock market. This simple test, although not thought of as such, was an example of a form of momentum investing.

Moving averages are rarely considered momentum investing. But moving averages are effective for the same reason that other momentum techniques are. Moving averages work because trends exist and generally do so for longer than some believe they should.

Efficient Market Theory (EMT) proponents are unable to explain this aberration in terms of their theory.

 

What Is Momentum Investing?

Momentum investing is predicated on corrections in stock or market pricing taking longer than the “instantaneous” adjustment predicted by EMT. If adjustment were immediate, excess returns would not be possible using a momentum strategy. However, the adjustment occurs more slowly than theory suggests it should. As a result, it has been shown that investors can use momentum to profit from buying stocks which are trending up and selling stocks which are trending down.

Tom Petruno of UCLA provides an overview of the momentum anomaly:

Conventional wisdom says that once any stock-picking strategy nears “sure thing” status it should be doomed. If everyone knows the secret to vast riches, how could the strategy possibly work anymore?

But there is a successful strategy that has been followed — and widely discussed — for decades, yet somehow persists as a relatively reliable money-maker: “momentum” investing, which is betting that the stock market’s recent winners will remain winners in the near term and, likewise, that the recent losers will remain losers. The strategy also is known as “relative strength” investing.

In the academic world, the pioneering research on momentum was a 1993 study published in the Journal of Finance by Narasimhan Jegadeesh and Sheridan Titman, both at UCLA Anderson at the time. They documented how strategies of buying recent stock winners and selling recent losers generated significantly higher near-term returns than the U.S. market overall from 1965 to 1989.

Regardless of why, momentum investing continues to offer unusual possibilities of profit.

The risk of following this strategy appears small. Even if the benefits were to disappear (a rational expectation) that does not mean losses would be incurred. Without the momentum effect one should expect normal market results from the selected securities.

How Momentum Is Calculated?

Momentum is a measure of how well a stock, ETF or mutual fund has performed over a recent period of time. All momentum investing uses ranking to select securities. Popular forms of ranking are the following:

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Disclaimer: Rankings are not recommendations. They are information which you may utilize as you see fit.  more

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Bill Myers 6 months ago Member's comment

Congrats on the Editor's Choice!

Monty Pelerin 6 months ago Author's comment

Thank you.

Adam Reynolds 6 months ago Member's comment

Great read.

Monty Pelerin 6 months ago Author's comment

Thanks for your comment.