Betting on price momentum

“Don’t fight the tape.”

“Make the trend your friend.”

“Cut your losses and let your winners run.”

“These Wall Street maxims all mean the same thing—bet on price momentum. Of all the beliefs on Wall Street, price momentum makes efficient market theorists howl the loudest. The defining principle of their theory is that you cannot use past prices to predict future prices. A stock may triple in a year, but according to efficient market theory, that will not affect next year. Efficient market theorists also hate price momentum because it is independent of all accounting variables. If buying winning stocks works, then stock prices have “memories” and carry useful information about the future direction of a stock.”

James O’Shaughnessy, What Works on Wall Street: A Guide to the Best-Performing Investment Strategies of All Time 1st Edition (1996) 


Momentum as a stand alone investment strategy

One observation I regularly share is the constant flow of research papers and books about topics I am interested in. Specifically, these topics are listed on the “About” page, but they are primarily those with the potential to create positive asymmetry in the P/L (that is: more profit than loss). The “momentum” subject is a big one for me, since I have operated directional trend systems for more than a decade. Momentum is sometimes called relative strength, or inertia, or trend-following. There are now more than 300 papers I know of documenting evidenced of momentum: whatever trend has been within the last year tends to continue. It’s interesting reading these research papers. They are sometimes written by academics at a University and sometimes by research at an investment company. The funny thing is they are rarely written by an investment manager who has strong performance history actually doing what they write about. I wouldn’t dare write a paper specifically about what I do that works. Nevertheless, these researchers share their opinions and only a few of us know how correct or wrong they may be.  You see, a research paper is just a study or opinion, we can never really prove something true since it can some day be proven untrue. Think: swans are white, until you see a black one. As I see it, the only people qualified to say so is if they themselves have good actual performance history doing these things. Experience matters, but research isn’t so much about experience as it is thinking deeply about a subject and offering ones views and findings.

I just got in my inbox a new paper by Ryan Larson Hot Potato: Momentum As An Investment Strategy (August 2013).

He concludes:

So what are investors to do with momentum? Our conclusion is that momentum is inadvisable as a stand-alone strategy due to the risk of precipitous losses. Rather, we suggest that long-term investors seeking to tap more than one source of equity premium choose another, more stable factor for their core investment strategy (value is certainly a strong candidate), and consider adding momentum as a short-term trading strategy when market conditions are favorable.

I agree that momentum (or relative strength) by isn’t best used as a stand alone strategy, but adding some other strategy like “value” to it isn’t the answer. Momentum (or relative strength) needs active risk management.

The role of shorting, firm size, and time on market anomalies


There are now more than 300 published papers providing evidence of the persistence of price trends (inertia/momentum). We point out the constant flow of new papers adding to the evidence of relative price strength as a market inefficiency (often called a market anomaly by academics). I call it velocity.


We examine the role of shorting, firm size, and time on the profitability of size, value, and momentum strategies. We find that long positions make up almost all of size, 60% of value, and half of momentum profits. Shorting becomes less important for momentum and more important for value as firm size decreases. The value premium decreases with firm size and is weak among the largest stocks. Momentum profits, however, exhibit no reliable relation with size. These effects are robust over 86 years of US equity data and almost 40 years of data across four international equity markets and five asset classes. Variation over time and across markets of these effects is consistent with random chance. We find little evidence that size, value, and momentum returns are significantly affected by changes in trading costs or institutional and hedge fund ownership over time.

They find the momentum premium exists and is stable across all size groups and the entire 86-year period—it was persistent in all four 20-year periods examined, including the most recent two decades that followed the initial publication of the original momentum studies.

The role of shorting, firm size, and time on market anomalies Journal of Financial Economics, Volume 108, Issue 2, May 2013, Pages 275-301
Ronen Israel, Tobias J. Moskowitz