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Momentum is the tendency for assets that have outperformed recently to continue outperforming over intermediate horizons. It’s one of the most robust and well-documented factors in finance.

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Beginner

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What It Means

Momentum is simple: stocks that have been going up tend to keep going up, and stocks that have been going down tend to keep going down - at least for a while. It’s about riding trends, not fighting them.

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Portfolio Example

Stock X rose 30% over the past year while Stock Y fell 15%. A momentum strategy would buy Stock X (the winner) and avoid or sell Stock Y (the loser), betting that these trends continue.

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The Key Insight

Momentum works over intermediate timeframes (3-12 months). It’s not about day trading or long-term value - it’s about capturing persistent trends before they reverse.

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Why It Matters

Momentum is one of the strongest factors in investing. It works across asset classes (stocks, bonds, currencies, commodities) and across countries. Understanding it helps explain market movements and can improve returns.

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Advanced

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Time Horizon Matters

Different horizons show opposite effects:

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Typical Implementation

Skipping the most recent month is critical. Including it reduces momentum returns significantly due to short-term reversal effects.

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Types of Momentum

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Why Momentum Works

Behavioral Explanations:
  • Underreaction: Investors are slow to update beliefs on new information
  • Herding: Trend-following creates self-reinforcing cycles
  • Disposition Effect: Investors sell winners too early, hold losers too long
  • Confirmation Bias: Investors seek information confirming existing trends
Risk-Based Explanations:
  • Crash Risk: Momentum strategies suffer severe losses during reversals
  • Liquidity Risk: Momentum stocks may be harder to trade during stress

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Historical Performance

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The Momentum Crash Risk

Momentum strategies experience severe crashes during market reversals. In 2009, momentum lost 50-80% in just 2 months as beaten-down stocks rallied sharply and prior winners collapsed.
Crash Characteristics:
  • Occur during sharp market reversals (V-shaped recoveries)
  • Often follow prolonged market declines
  • Can wipe out years of gains in weeks
  • Most severe when momentum spread (winners vs. losers) is extreme

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Implementation Considerations

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Momentum + Value Diversification

Momentum and value tend to work at different times:

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Data Requirements

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Related Terms

Factor Investing

Momentum is a key factor

Value Investing

Often negatively correlated

Drawdown

Momentum has severe drawdowns