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.
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 accounted for, and one should not expect to do better than the market itself.
Behavioral finance challenges these assumptions and provides logical reasons momentum investors could earn consistently high profits:
Anchoring bias – investors are slow to react to new information and over-rely on past data
Confirmation bias – investors ignore information that is contrary to their prior beliefs
Disposition effect – investors sell winners too soon and hold on to losers too long
Herding – buying begets more buying so that trends persist and overextend
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.