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Momentum investing is buying stocks or other equities that have had high returns over the past three to twelve months, and selling those that have had poor returns over the same period. It has been reported that this strategy yields average returns of 1% per month for the following 3-12 months (Jegadeesh and Titman).

While consensus exists about the validity of this claim, economists have trouble reconciling this phenomenon using efficient market theory. Two main hypotheses have been submitted to explain the effect in terms of an efficient market. In the first, it is assumed that momentum investors bear significant risk for assuming this strategy, and thus the high returns are compensation for the risk. The second theory assumes that momentum investors are exploiting behavioral shortcomings in other investors, such as investor herding, investor over and underreaction, and belief perserverance.

Seasonal effects may help to explain some of the reason for success in the momentum investing strategy. If a stock has performed poorly for months leading up to the end of the year, investors may decide to sell their holdings for tax purposes. Increased supply of shares in the market drive its price down, causing others to sell. Once the reason for tax selling is eliminated, the stock's price tends to recover.

Other sophisticated investors may react to inefficient pricing of a stock caused by momentum investing using the tool of arbitrage.

It is believed that George Soros (1987) used a variation of momentum investing by bidding the price up of already overvalued equities in the market for conglomorates in the 1960's and Real Estate Investment Trusts in the 1970's. This strategy is termed positive feedback investing.

Richard Driehaus, the founder of Driehaus Capital Management, Inc., is widely considered the father of momentum investing. This Chicago money manager takes exception with the old stock market adage of buying low and selling high. According to him, "far more money is made buying high and selling at even higher prices."

References

  • Jegadeesh, Narasimhan and Titman, Sheridan, 1993, Returns to buying winners and selling losers: Implications for stock market efficiency, Journal of Finance 48, 65-91.
  • Schwager, Jack D., 1992, The New Market Wizards: Conversations With America's Top Traders, John Wiley & Sons, Inc., NY, p. 224, ISBN 0-471-13236-5.
  • Soros, George, 1987, The Alchemy of Finance, Simon and Shuster, New York.
  • Tanous, Peter J., 1997, Investment Gurus, New York Institute of Finance, NJ, ISBN 0-7352-0069-6.
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