Why Does Momentum Work?

See the Top Scoring Momentum Stocks in Today’s Market: View Now There are varying theories as to why momentum investing works. Some investors believe that momentum stocks are riskier and that they should be compensated for that risk with greater returns than the overall market. But some of the leading experts tend to credit behavioral biases as the likely driver of the momentum premium. Experts believe momentum exists due to investor overconfidence and skepticism, where skeptics sell too early, giving room for further upside in stocks as positive market developments take hold. Other possible behavioral tendencies that may explain why momentum works include: Cognitive Dissonance: Investors tend to react more logically to information that confirms their beliefs and discount information that runs counter to their thinking. As a result of this, momentum may take hold more easily. Inattention: Investors tend to under-react to a number of small changes vs. one less frequent major change. Because of this, price anomalies like momentum can exist. Disposition Effect: This idea centers around holding losing stocks for too long and selling winning stocks too early. Because investors feel the pain of losses more than the joy of gains, many avoid selling losing stock positions and instead sell those with gains. In addition, high momentum in a stock may turn out to help a company’s underlying business, a concept called reflexivity. Companies with strong performing stocks may be able to use an elevated stock price to make profitable acquisitions, attract the best and brightest talent, compensate their workers through lucrative stock options and even issue new equity where the proceeds can be used to fund various strategic initiatives or positive financial developments (i.e., paying down debt). Strong momentum stocks may benefit from a positive feedback loop where fundamentals eventually benefit from the strength of the stock. This approach doesn’t come without risks. When looking at short-term momentum, reversals can happen regularly. For example, stocks with the best one-month performance are likely to underperform in the following month. This is one of the key reasons why intermediate term momentum is utilized by most momentum investors – it helps avoid this reversal effect. Also, when market leadership transitions from one type of stock to another, a momentum strategy will have to adjust and can struggle. This content is brought to you by Validea

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