dual momentum investing

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.”

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

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

Video Presentation of Dual Momentum

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 seminal research of Jegadeesh and Titman in the early 1990s, momentum has been one of the most heavily researched finance topics. Continuing research has firmly established momentum as an anomaly that works well in nearly all markets including equities, stock indices, currencies, commodities, real estate, and bonds. Out-of-sample research has shown momentum to be effective from the early 1800s up to the present. Research also shows momentum 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 mostly use momentum the same way Cowles and Jones discovered it by looking at relative momentum and individual stocks. Relative momentum looks at the performance of one asset versus other assets. But there is also absolute momentum that uses an asset’s own past performance to infer future performance. Absolute momentum can reduce downside exposure as well as 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 relative momentum with individual stocks and ignore absolute momentum. In order to remedy this situation, we developed a publically available simple model called Global Equities Momentum (GEM). It applies dual momentum to geographically diversified stock market indices. We also have more advanced proprietary models that we license to family offices and investment advisors.