Momentum Investing: Ride Recent Winners Systematically

Key Takeaways

• Momentum investing ranks assets by past 3–12 month returns and buys winners while selling or underweighting losers.
• Jegadeesh and Titman's 1993 study showed statistically significant excess returns from a 12-1 month US stock momentum rule.
• Ignoring the skip month, which filters out short-term reversal, is a frequent implementation error that pollutes the signal.
• Momentum diversifies well in a portfolio because its drawdowns typically do not overlap with value factor drawdowns.

What It Is

A momentum strategy ranks a universe of assets by past return over a lookback window, typically 6 to 12 months, then buys the top-ranked assets and sells or underweights the bottom-ranked. It is a relative strategy, not an absolute one. It does not care whether the market is up or down overall. It cares which names are leading.

Jegadeesh and Titman's 1993 paper, Returns to Buying Winners and Selling Losers, showed that US stocks ranked on trailing 3 to 12 month returns delivered statistically significant excess returns over the next 3 to 12 months. Mark Carhart later added momentum as a fourth factor (UMD, up-minus-down) to the Fama-French three-factor model in his 1997 mutual fund study, establishing it as a standard risk factor.

The Intuition

Markets underreact to new information over short horizons. A company beats earnings, raises guidance, or wins a contract, and the price does not fully reflect the news on day one. Over weeks and months, the stock drifts in the direction of the surprise as more investors digest the change. That drift is the momentum premium.

There is also a behavioural story. Investors anchor on old information, chase recent winners too late, and avoid recent losers too long. These biases reinforce trends past the point where fundamentals alone justify them. Trends eventually reverse, which is why momentum signals carry expiry dates rather than being permanent.

How It Works

A canonical cross-sectional momentum recipe has three parameters:

Formation window: 12 months of past returns
Skip month: 1 month (exclude the most recent month)
Holding window: 1 to 3 months, then rebalance

The skip month matters. Very short-term reversal, where last week's winners often give back some gains next week, contaminates signals built on the most recent data. Dropping the latest month cleans the signal without losing much of the 6 to 12 month drift.

Asness, Moskowitz, and Pedersen's 2013 paper Value and Momentum Everywhere generalised the idea. They found consistent value and momentum premia across eight markets and asset classes, including individual stocks, country equity indices, government bonds, currencies, and commodities. Momentum and value were negatively correlated both within and across asset classes, which is why many factor portfolios combine the two: the drawdowns tend not to overlap.

Momentum returns are real but come with painful features. The strategy crashes during sharp reversals, most famously in March 2009 when short-loser portfolios rebounded violently. Sizing and a volatility overlay can reduce these tails.

Worked Example

Suppose on the last trading day of the month you rank the S&P 500 by total return from 13 months ago to 1 month ago. You skip the most recent month to avoid reversal.

You build a long-only portfolio of the top 50 names by this rank, equal weighted. You hold it for one month, then repeat the ranking and rebalance. A long-short version would add a short leg of the bottom 50.

Over long samples, the long leg has historically outperformed the market by a few percent per year, and the long-short combination has delivered a positive Sharpe ratio independent of the market. The trade-offs are turnover (often 200 percent per year or more), tax inefficiency from short-term gains, and the occasional crash month that can erase a year of patient edge.

Common Mistakes

1. Confusing momentum with trend-following. Cross-sectional momentum ranks assets against each other. Time-series trend-following buys an asset when its own price is above a moving average and sells when below. Both are valid, but they express different bets and produce different drawdown profiles.

2. Ignoring the skip month. Using the full 12-month window including the most recent week pollutes the signal with short-term reversal. The literature is consistent on skipping the last month or last week, yet many retail implementations ignore the step.

3. Underestimating turnover costs. Momentum rebalances frequently. Transaction costs, bid-ask spreads, and taxes can easily eat half the gross premium for a retail investor. Backtests that assume zero cost overstate the live return by a wide margin.

4. Giving up after a crash. Momentum crashes in 2009 and smaller ones in 2020 and 2022 shook out many investors. The factor has historically recovered, but only if you stayed in. Sizing the allocation so a typical 20 percent drawdown is survivable matters more than perfect timing.

5. Using momentum as a single-factor portfolio. The academic literature shows value and momentum combined diversify each other. A pure momentum sleeve is concentrated and crash-prone. Combining it with value or quality usually improves risk-adjusted returns.

Frequently Asked Questions

Q: What is momentum investing in simple terms? Momentum investing means buying stocks that have risen the most over the past several months and selling or avoiding those that have fallen the most, on the premise that price trends persist long enough to profit from.

Q: How does momentum investing affect investment decisions? It replaces fundamental research with a systematic ranking process. You rebalance frequently, accept high turnover, and hold positions for weeks to months rather than years. Tax efficiency drops and transaction costs rise versus a buy-and-hold approach.

Q: What is a real-world example of momentum investing? The article's S&P 500 example builds a monthly long-only portfolio of the top 50 stocks ranked by trailing 12-1 month return, equal weighted, and rebalances each month. The long leg historically outperformed the market by a few percent per year before costs.

Q: How can investors use momentum investing in their portfolio? Use a 12-1 month lookback, skip the most recent month to avoid reversal contamination, and combine with value or quality to dampen crash risk. Size the momentum sleeve modestly to survive the occasional sharp drawdown months.

Q: How is momentum investing different from trend following? Momentum investing is cross-sectional, it ranks stocks against each other. Trend following is time-series, it evaluates each asset against its own past return. Momentum is always fully invested on both sides; trend can be net long, short, or flat.

Sources

1. Jegadeesh, N. and Titman, S. (1993). "Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency." Journal of Finance, 48(1), 65-91. https://onlinelibrary.wiley.com/doi/abs/10.1111/j.1540-6261.1993.tb04702.x
2. Carhart, M. M. (1997). "On Persistence in Mutual Fund Performance." Journal of Finance, 52(1). https://onlinelibrary.wiley.com/doi/10.1111/j.1540-6261.1997.tb03808.x
3. Asness, C. S., Moskowitz, T. J., and Pedersen, L. H. (2013). "Value and Momentum Everywhere." Journal of Finance, 68(3), 929-985. https://onlinelibrary.wiley.com/doi/abs/10.1111/jofi.12021

Disclaimer

This article is educational content only and is not financial advice. Nothing here is a recommendation to buy, sell, or hold any security. Consult a licensed advisor before making investment decisions.