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Momentum Premium 101
Momentum Premium: Returns
 
Momentum is the tendency for good past performance to continue. In stocks, the premium was first documented in Narasimhan Jegadeesh and Sheridan Titman’s 1993 Journal of Finance paper titled “Returns to Buying Winners and Selling Losers.” In the U.S., the momentum premium has averaged 9.7 percent per year over 1927–2010. The returns of this “academic” version of momentum essentially involve buying stocks that have done really well over the past 12 months and selling the ones that have done very poorly over the past 12 months. (I’m simplifying a bit here, but this is the gist of it.)
 
The momentum premium has also been discovered in most international stock markets and in other asset classes. In short, it has been incredibly robust and the notion that momentum’s discovery was nothing more than a data-mining exercise (the idea that if you give this guy a high-powered computer, loads of data and time, he’s bound to find something) has been thoroughly discredited. Further, the idea that momentum doesn’t survive transaction costs appears dubious too, since it appears to exist in large companies as well as small ones.
 
Momentum Premium: Risk
 
Annual volatility of the momentum premium has run about 16 percent per year, so clearly there are years where the return of momentum is negative. If we look at other measures of risk—for example how momentum does when the stock market is doing poorly—the results make a risk-based explanation for its existence hard to fathom. During years where the equity premium was negative, the average return to momentum was 10.2 percent per year. Further, the correlations of momentum with most every other premium are very low or negative, meaning it has high potential diversification benefits. Small wonder that momentum has proven to be one of the biggest challenges to the efficient market hypothesis.
 
Momentum Premium: Why Does It Exist?
 
Cricket Chirping
 
No, Really, Why Does Momentum Exist?
 
I don’t think anybody knows, but most believe it’s a behavioral phenomenon. One common explanation is that investors underreact to positive information and overreact to negative information. Somehow, though, these reactions get corrected over the next six to 12 months. I’ve also heard explanations that are motivated by loss aversion and investors’ unwillingness to realize capital gains. At this point, I’ve not heard any really convincing explanations and, like a lot of topics in finance and economics, I think the best that we can say is we don’t really know why it exists.
 
Random Links and Commentary of the Week
 
After months of intense focus group sessions and consultation with the blog’s marketing department, I have now expanded this section to include commentary in addition to links.
 
This week I am going to keep It simple and pass along a link to one of the most insightful, thought provoking commentators on U.S. society and culture: Kenny Powers. Here’s Kenny’s take on professional exercising. This is a solid go-to clip when you need a good laugh.
 
Copyright © 2012, Buckingham Family of Financial Services. This material and any opinions contained are derived from sources believed to be reliable, but its accuracy and the opinions based thereon are not guaranteed. The content of this publication is for general information only and is not intended to serve as specific financial, accounting or tax advice. Information regarding references to third-party sites: Referenced third-party sites are not under our control, and we are not responsible for the contents of any linked site or any link contained in a linked site, or any changes or updates to such sites. Any link provided to you is only as a convenience, and the inclusion of any link does not imply our endorsement of the site.

Comments

Momentum effect on rebalancing theory?

J: Why doesn't the Momentum premium contradict the theory of rebalancing? Perhaps it could affect the frequency of rebalancing to let some of the momentum play out? I wonder if research can detect a sweet spot, like perhaps 2 years vs. annually?
at 3/17/2012 11:45 AM

Momentum & rebalancing

Couple of points here...first the momentum described in the post is "relative" momentum as opposed to "absolute" momentum. I think of relative momentum as within asset class momentum e.g., which individual stocks within the stock asset class have positive momentum and which have negative momentum.

Your question applies more to asset class level momentum or what I think of as absolute momentum. There is some support for this kind of momentum as well (see the paper Time Series Momentum by Moskowitz, Ooi and Pedersen soon to be published in the JFE). It shows that there appears to be absolute momentum at the asset class level over about a 6-12 month time frame which seems to indicate to me that rebalancing asset classes back to target over shorter time horizons probably doesn't make much sense due to momentum and other reasons like tax costs and transactions costs. So I definitely hear what you are saying but I wouldn't necessarily argue that you need to extend rebalancing time horizon out beyond a year.

Thanks for the comment!
at 3/17/2012 3:02 PM

nice

great article
at 6/5/2012 11:21 PM

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