The simplest explanation — “I can’t believe you know something I don’t” — may trump all the rest
UCLA Anderson’s Avanidhar Subrahmanyam has spent a good chunk of his career researching one of Wall Street’s biggest mysteries: momentum, which is the tendency of the stock market’s recent winners to remain winners in the near term and, likewise, for recent losers to remain losers for a while.
Momentum investing’s strong record of success as a strategy has vexed academics and market professionals alike because it defies one of modern finance’s key tenets: that markets are efficient. In part, efficiency means that no trading pattern should persistently beat the market because as soon as investors learn it, stock prices should quickly adjust to remove the easy reward potential.
Decades of research have sought to explain the momentum anomaly in the context of the efficient market theory. Now, in a working paper, Nanyang Technological University’s (Singapore) Jiang Luo, Subrahmanyam and University of Texas’ Sheridan Titman suggest that much of that research amounted to overthinking. Instead, they propose an explanation rooted in basic human nature. Many investors, they say, simply refuse to believe that their competition in the market might know more than they do. In the case of rising stocks, that skepticism acts as a brake, slowing their advance but also extending it.
Luo, Subrahmanyam and Titman refer to their new model of momentum as “parsimonious.” Or, as Subrahmanyam said in an interview, they believe that momentum is driven by the most “minimal and reasonable assumptions about human behavior.”
It was in 1993 that Titman, then at UCLA, and his colleague Narasimhan Jegadeesh, first documented how, from 1965 to 1989, strategies of buying recent stock winners and selling recent losers generated significantly higher near-term returns than the U.S. market overall.
They set down the basic time frame for momentum-investing success as a 3-to-12-month window on either side. So a stock’s relative performance (up or down, versus the market) over the previous three to 12 months typically predicted its relative performance for the following three to 12 months. The paper focused in depth on a portfolio that selected stocks based on their previous six-month returns, held them for six months, and then sold. That strategy produced an extra return of about 1% per month above what would have been expected, Jegadeesh and Titman found. Over time, that bonus over the market return adds up to a substantial premium.
Since that pioneering study, other researchers have documented how momentum trading strategies (also known as “relative strength” trading) have been profitable not just on Wall Street but in foreign stock markets, bonds, currencies and commodities. Of course, the strategy isn’t foolproof. It doesn’t work every time, and is particularly dangerous to pursue in bear markets (as in 2008). But its long-term success has been undeniable.
Could Subrahmanyam and his colleagues finally have the best answer as to why? “We believe so,” Subrahmanyam said in an interview. But as academics, he added, “We cannot take a definitive position.” It’s now for other researchers to try to prove them wrong — or right.