Optimal Momentum™ Optimal Momentum™

Isaac NewtonMomentum is based on the Newtonian notion that a body in motion tends to stay in motion. The classical economist David Ricardo translated momentum into investment terms with the oft quoted phrase, “Cut your losses; let your profits run on.”


Momentum dominated the 1923 book, Reminiscences of a Stock Operator, about the legendary trader Jesse Livermore. Momentum-based velocity ratings were used in the 1920’s by HM Gartley and published in 1932 by Robert Rhea. George Seaman and Richard Wycoff wrote books in the 1930s that drew upon momentum principles.


Momentum also has strong roots in academic research. The first scientific momentum study was published by Alfred Cowles and Herbert Jones back in 1937. Cowles and Jones compiled stock performance statistics from 1920 through 1935. They found the strongest stocks during the preceding year remained strong the following year.


Momentum research languished after Cowles and Jones. Until behavioral finance caught on in the 1980s, the efficient market hypothesis had a firm grip on academic finance.

Under efficient market theory, all information is fully accounted for, and one should not expect to do better than the market itself.

Behavioral finance challenged these assumptions and provided logical reasons why momentum investors could earn consistently high profits:

Anchoring effect – investors are slow to react to new information.


Disposition effect – investors sell winners too soon and hold losers too long.


Herding effect – buying begets more buying so that trends persist.


With behavioral finance to support it logically, momentum research took a giant leap forward in 1993 with the publication of "Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency" by Jegadeesh and Titman. This seminal study used modern analytic methods to validate the findings of Cowles and Jones.    


Since the research of Jegadeesh and Titman in the early 1990's, momentum has been one of the most heavily researched finance topics. Continuing research has firmly established momentum as an anomaly that works well with nearly all markets including equities, stock indices, currencies, commodities, real estate, and bonds. Out-of-sample research has shown momentum to be valid from the early 1800’s up to the present. Research shows it works best when applied to geographically diversified stock indices.


The premier market anomaly is momentum. Stocks with low returns over the past year tend to have low returns for the next few months, and stocks with high past returns tend to have high future returns.

Fama & French


Investors today use momentum the same way it was discovered by Cowles and Jones in 1937 using relative momentum.


Relative momentum looks at price strength with respect to other assets. Absolute momentum uses an asset’s own past performance to infer future performance. Absolute momentum can reduce downside exposure as well enhance returns. The best approach is to use both types of momentum together. That is what dual momentum is all about.


But most applications of momentum today use momentum with individual stocks and ignore absolute momentum. In order to remedy this situation, we developed rules-based models using both relative and absolute momentum applied to geographically diversified stock market indices.


Dual Momentum Investing: An Innovative Strategy for Higher Returns with Lower Risk


by Gary Antonacci describes dual momentum in detail and how you can profit from it.


For more on momentum investing, please see our FAQ page, our Performance page, and our Dual Momentum blog.

Momentum

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