Why Investor Behaviour Makes Momentum Strategies Outperform

21st May '18 by Ben Hobson

7 comments 9371 reads

Richard Driehaus, the American fund manager, once said he took exception to the idea of buying low and selling high. He wasn’t interested in picking up cheap stocks and waiting for them to recover. Instead, as he explained: “I believe far more money is made by buying high and selling at even higher prices.”

In essence, Driehaus was describing momentum investing. He went on to earn guru status by showing (through his fund performance) that momentum was profitable in the real world - and not just in academic research.

Momentum is the tendency for price trends to persist. It can cause securities with rising prices to rise further, and securities with falling prices to fall further. As with other factors like ‘value’ and ‘quality’, momentum has a reputation for being a powerful driver of stock market profits.

Over the past 30 years some of the smartest minds in finance academia and hedge fund management have explored momentum in detail. They’ve also come up with various strategies that try to capture it. But while the strategies have proved to be powerful, intriguingly there’s still a debate about why momentum exists at all...

Momentum strategies in action

At Stockopedia, our guru-inspired momentum strategies have collectively been one of the best performing investment styles over the past five years. Currently leading the group is an approach inspired by asset manager James O’Shaughnessy called Tiny Titans. It’s seen a near 200 percent return over that time (rebalanced quarterly, ex-costs).

Between them, the strategies model some of the most compelling research into momentum investing. Some like Price Momentum and 52 Week Highs focus solely on strong price trends. Others, like Earnings Surprises, Earnings Upgrades and Bold Earnings Revisions, look for signs of ‘earnings momentum’, where companies are outperforming against analyst forecasts.

Strategies like Josef Lakonishok Momentum and Richard Driehaus Momentum, seek to combine both price and earnings momentum. While those like James O’Shaughnessy and Value Momentum, combine momentum with value to create twin-factor strategies.

Strategy	Year to Date (pc)	1 Year (pc)	5 Years (pc)
James O’ Shaughnessy Tiny Titans	+8.4	+16.5	+198.5
Earnings Surprises	+5.0	+51.7	+161.8
Josef Lakonishok Momentum	+5.2	+18.7	+124.2
Price Momentum	+9.7	+25.2	+121.7
Value Momentum	-1.3	+3.6	+107.9
Richard Driehaus Momentum	+4.9	+24.0	+81.5
52 Week High Momentum	+5.2	+18.3	+69.9
Earnings Upgrade Momentum	+14.8	+27.2	+57.4
Bold Earnings Revisions	+5.4	+2.1	+50.6
Stockopedia MomentumRank (top decile)	+4.3	+64.7	+145.6

Data as of 18 May 2018

In addition to the guru strategies, Stockopedia’s own

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iwright7

22nd May '18

Another excellent article. I am reminded of a wonderful quote from Will Rogers in 1929: ‘Don’t gamble’; take all your savings and buy some good stock and hold it till it goes up, then sell it. If it don’t go up, don’t buy it.”

More recently Wes Gray of Quantitative Momentum fame suggested that the objective with momentum is to front run market expectations and that to capture this anomaly we need to look for signals such as nearness 52 Wk High and Earnings Surprise.

Whatever the reasons for the Momentum effect, because it has behavioral causes it is more likely to continue to persist into the future than other factors. The trick is to be aware of our collective human biases and then exploit them.

NKE12

You should read - perhaps you have - Gary Antonacci on Dual Momentum Investing

he examines this subject in some depth; there are a number of factors at play

fazm

take a look at the research into acceleraiton as a possible driver for the momentum factor. .The problem with momentum is the crashes which Gary Antonacci solves with dual mometum which is effectivly overlaying time series momentum (trend following) over cross sectional momentum (the one we all know about).. Earnings suprises do cause acceleraiton when they go outside the analysts estimate range. PEAD also comes into it here. Main thing for me is trend following seems interesting due to its "skew" to offset all the aother annomolies which have the opposite skew. -- see value, vol , market, et al

Peter Craven

The article mistakenly fails to differentiate between "Price Trend Momentum" and "Performance Trend Momentum".
Performance trends encompass the compound gain of a share based on both its price rise and dividend income over a period of time.
The numbers alone cannot tell the whole story without the investor making a careful study of the companies results and presentations. I'm all for momentum investing with caveats. After all a company with a good track record (EG DCC) is more likely to keep performing than one with a poor track record such a BT.A.
My observation highlights the misleading stock market maxim that past performance is not a guide to the future.
However, a Warren Buffet said "Beware of geeks with formulas".

Micky3

Very good and it truly works. But it works even better if linked to Value. Try your VM list and compare with Momentum only. You will see it overperforms substantially. +177% over 5 years compared to +151% actually.

adatherton

This article touches on the central point of medium-term trading/investing - trend vs range. Notably the Stocko momo score underperforms year to date, but does really well in the longer term. Short term is range, long term is trend. The difficulty is determining the timeframe. (No issue for buy and hold passives, but huge for active investors who want to make 25% pa)

23rd May '18

I agree that VM is a winning strategy, but so is QM.Every mourning I look at the Stockrank Movers for QM companies that score over 80 and exibit double digit improvements over the last 7 days, as new investment ideas. This ties nicely with Will Rogers quip about obout only buying Quality stocks that go up. Combine high and improving QM with other anomalies such as low Beta/low Volitility etc and it’s a winning formula that lets me sleep at night.

Why investor behaviour makes momentum strategies outperform

Momentum strategies in action

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Ben Hobson

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