It has been two decades since academics zeroed in on what we today call the “momentum effect” in stock markets. Momentum is basically the tendency of winning stocks (i.e. stocks that have outperformed the market in recent times) to keep winning and losing stocks to keep losing.

It is based on the idea that once a stock establishes a trend, it is more likely to continue in that direction instead of moving against the drift. Unlike the hugely followed Value or Growth styles, this strategy has barely anything to do with the fundamentals of a company, and instead works with the human penchant to extrapolate current trends into the future.

At the core, momentum investing calls for investors to “Buy High, Sell Higher.”

Why Does Momentum Strategy Work?

There is a simple reason behind this. It works because we are humans!

There’s a whole laundry list of behavioral biases that most investors exhibit, and these emotional responses and mistakes are the very reason that momentum strategy works. For instance, we all know of investors who are afraid to book losses, and hence hold on to losing stocks for too long, hoping that they will spring back to their original prices. On the other hand, investors sell their winners way too early.

Furthermore, investors initially tend to under-react to news, events or data releases. However, once things become clear, they tend to go with the flow and overreact, causing dramatic price reactions.

These behavioral problems extend trends and thus open up huge opportunities for momentum players. So basically, it’s a way to profit from the general human tendency to extrapolate current trends into the future.

Momentum investing is based on that gap in time that exists before the mean reversion occurs, i.e. before prices become rational again.

Momentum versus Other Styles

It is worth reflecting over how the momentum strategy compares with other styles of investing over time. Recent research indicates that the size premium for small-cap stocks has shrunk dramatically since the 1980s and value premium has declined radically since the 1990s. Academics are of the opinion that once research on factor premiums (like size and value) becomes known to public, the investment world catches on and the premium gradually erodes.