A recent article in The Economist newspaper, entitled "Why Newton Was Wrong", explores the effect of momentum in investing. Several studies, presented in the article, have all demonstrated that picking the best performing stocks from the previous 12 months would provide market-beating results. Moreover, this momentum effect exists for other securities markets, such as commodities and currencies, and has been observed for decades.
While several other stock market "anomalies" have been observed and then disappeared due to exposure, the persistence of the momentum effect had been a mystery. Nonetheless, the Economist puts forth possible explanations. Namely, the momentum effect may represent a lag between the perception of companies and their actual results. When investors have a negative view of a business, they tend to dismiss positive news about it as a blip. Then when the good news continues, they pile into the stock. Moreover, the effect may be carried over as fund managers proceed with "window-dressing" their portfolios by buying securities that had recently gone up, thus contributing to further boost stem.
Momentum strategies have been devised over the past to exploit the effect. These strategies have grown more complex, sometimes involving trading at incredible speeds. However that has made some of those strategies vulnerable to random movements in the markets. Moreover, momentum investing, over long time periods, loses out to value investing as prices of unfavored securities are driven down to bargain territory. It is noted that momentum investing has tended to misfire horribly at times and the article muses that the strategy may be behind the creation and maintaining of asset price bubbles. Some of this was not necessarily unknown in value investing circles. In its "What Has Worked In Investing" paper, noted value investing firm Tweedy Browne cites studies that point out how value investing outperforms momentum investing over periods longer than 12 months. Some of this had also been reprinted in "The Little Book of Value Investing" by the late Christopher Browne, former director at Tweedy Browne.
