Momentum 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.” By following his own advice, Ricardo retired at the age of 42 having amassed a fortune of 65 million in today’s dollars.
Momentum style investing was alive and well during the 1920s and 1930s. Momentum dominated the 1923 book, Reminiscences of a Stock Operator, about the legendary trader Jesse Livermore. Momentum-based relative 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.
In the 1950s, George Chestnutt published a newsletter that ranked relative strength momentum in stocks and industries. He used this approach to manage American Investors Fund, which, from January 1958 through March 1964, had a cumulative return of 160% versus 83% for the Dow Jones Industrial Average.
The “Lion of Wall Street,” Jack Dreyfus, relied on momentum by buying stocks making new highs. His Dreyfus Fund was up 604% from 1953 to 1964 compared to 346% for the Dow Jones Industrial Average.
One of the more prominent momentum investors was the philanthropist and fund manager, Richard Driehaus. He was written about in Jack Schwager’s, The New Market Wizards. Driehaus used rotational relative strength to buy top performing stocks.
Perhaps the best-known investment paradigm is buy low, sell high. I believe that more money can be made by buying high and selling at even higher prices. –Richard Driehaus
Momentum has strong roots in academic research. The first scientific momentum study was published by Alfred Cowles and Herbert Jones in 1937. There were no computers back then, so Cowles and Jones painstakingly hand compiled stock performance statistics from 1920 through 1935. They found that the strongest stocks during the preceding year tended to remain strong during the next 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 reasons why momentum investors could continue to 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.
Initial underreaction is followed delayed overreaction caused by:
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 within and across nearly all markets including equities, stock indices, currencies, commodities, real estate, and fixed income. Research has shown momentum to be valid from the early 1800’s up to the present.
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 in much the same way as it was discovered by Cowles and Jones in 1937 - with specific look back periods and regular portfolio balancing.
Research has shown that momentum works best when it is applied to geographically diversified stock indices rather than to individual stocks, and when it incorporates absolute as well as relative momentum. Relative momentum looks at price strength with respect to other assets to determine future relative performance. Absolute momentum uses an asset’s own past performance to infer its 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.
Most applications of momentum today use momentum with individual stocks and ignore absolute momentum altogether. In order to remedy this situation, we constructed rules-based, benchmark models using both relative and absolute momentum applied to market indices.
by Gary Antonacci describes our dual momentum approach in detail and how you can profit from it.
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