How Momentum Can Reduce Risk And Enhance Returns In Your Portfolio Momentum is a hot topic of research in quantitative finance because according to the efficient market hypothesis, it shouldn’t exist. But its effects are pervasive. It has been used by many of Wall Street’s elite to make billions upon billions of dollars in profits for their hedge funds. In fact, it’s so pervasive that even Eugene Fama, the creator of the efficient market hypothesis, says that “momentum…is the premier market anomaly” which means that it creates the largest excess returns versus the market when compared to other anomalies such as value investing.
What Is Momentum? The term momentum was borrowed from Newton’s First Law of Motion, wherein an object in motion tends to stay in motion unless an external force is applied to it. Basically momentum is the observation that stocks tend to continue in the same direction that they’ve been trending over the recent past. So stocks, that go up tend to continue going up, and stocks that are going down tend to continue going down.
We can use momentum to determine which stocks to purchase in a portfolio because stocks with positive momentum tend to have positive returns over the near future (next 1 to 12-months) and vice versa for those with negative returns. Typically, researchers use 12-month returns to determine the magnitude of momentum of a stock. So a stock’s 12-month momentum is equivalent to its return over the past 12-months. There are numerous behavioral explanations for this but the simplest explanation would be that: Rising prices attract buyers. Falling prices attracts sellers.
Pretty simple right? Most of the time when the stock market is going up, people tend to crowd into the markets and wish to buy at any price. Conversely, when the market is going down, people tend to want to get out of the market and sell at any price they can before it hits bottom.
Now, there are two types of momentum: