Raman Kumar
Raman Kumar

Buy low, sell high. That has always been the layman’s mantra to investing in the stock market. However, according to billionaire investor Richard Driehaus, much more money is made by buying high, and selling even higher. This is the idea behind momentum investing, a strategy that Driehaus is considered, by some, to be the father of. While there are several somewhat different methods of momentum investing, all boil down to a simple approach – purchase stocks that have high returns over a set period and sell those that have poor returns.

But does this momentum, be it positive or negative, eventually reverse? That was the question that Yao Li, a recent Ph.D. graduate from the Department of Finance, and Raman Kumar, R.V. and A.F. Oliver Professor of Investment Management in the Department of Finance, set out to answer with their research.

“I had been thinking about performing research along these lines for about four or five years, but it wasn’t until Yao came to me with a similar idea that I decided to follow through with it by working with her,” explained Kumar.

Understanding investing is a prime focus for Kumar, who sees the practice as integral to the ongoing symbiotic relationship between people and business.

“I believe that the primary purpose of financial markets is to bring together those of us who want to save and invest part of our income and wealth in stocks and bonds for our future expenses and needs, and the businesses who are looking for funds to turn their ideas of producing and selling new products and services into reality.

“During their prime working years, individuals should spend less than what they typically earn, and they should save and invest part of their earnings for later needs,” he explained. “We all have time in our lives when we earn, and we all will have time in our lives when we will live off the past investments of our earnings. One of the main ideas behind investments is how to best invest money for those who want to save now and will need it later.”

Kumar and Li’s research found that, by examining positive and negative momentum stocks for a longer period relative to similar portfolios with no momentum, stocks with positive momentum, or winners, tend to persist in their momentum for only six months, and their higher returns are apt to fully reverse over time. They also found that stocks with negative momentum, or losers, continue with their negative momentum for about one year, and their lower returns do not tend to reverse over time.

According to Kumar, these trends are consistent with two distinct phenomena for winners and losers. First, the long-term reversal of the higher performance of winners is indicative of investors overreacting to positive news, which is potentially destabilizing for the stock prices. “It takes time for the market to correct itself and the higher returns eventually reverse,” said Kumar.

Second, the long-term non-reversal of the negative momentum of the losers suggests an underreaction to negative news, possibly because investors hold on to losers for too long. “People own the stocks they like,” Kumar said. “Overconfidence about the stocks they own and confirmation bias may cause the investors to initially underreact to negative news.” 

These results contradict previous research on the reversal of momentum, which found that the winner minus the loser momentum would eventually reverse in the long term. The reason, Kumar said, comes down to how the research was performed.

“Previous studies calculate the average return for the stocks in the momentum portfolio every month and compound them over time, which implies rebalancing every stock in the portfolio to have equal weights at the beginning of every month,” he explained. “The alternate strategy is to buy and hold the portfolio, which does not rebalance the stocks in the portfolio every month.

“Rebalancing the portfolio creates an upward bias in estimated returns, which becomes larger the longer the portfolio is held and the more volatile the stock prices are,” Kumar continued. “This upward rebalancing bias in estimated returns is very large for the lower-priced stocks in the negative momentum portfolio, and makes it appear as if the negative momentum stocks start earning higher returns and reverse in the long term. This creates a false narrative that the negative momentum is a consequence of overreaction to negative news. The upward rebalancing bias has been known and documented for the last 40 years in the context of other investment strategies, but has not been previously examined for the reversal of the momentum returns.”

Kumar stressed that the findings of their research are not necessarily aimed at changing any norms for investing. Rather, it is to simply understand the market better.

“Because of our research, we have a better idea as to what effect momentum has on prices. Is it a strategy that makes the prices more accurately reflect the available information, thereby making the market more efficient, or is it a strategy that moves the stock prices away from their true values, thereby making the market less efficient?” For losers or negative momentum stocks, the answer appears to be the former, but for winners or positive momentum stocks, it appears to be the latter.

According to Kumar, the more efficient the market is, the better suited it is for business innovation. That innovation then tends to lead to the betterment of the human condition.

“Wall Street connects investors and businesses on Main Street with each other, creating value for both. Businesses need money now and will pay it back later with profits and returns. Households have money now and will need it later. Without money from households to invest, those with good business ideas will see their ideas die. The primary role of the financial markets is to bring together, in the most efficient way possible, those who have funds to invest with those who have business ideas to innovate, produce, and distribute new and existing products and services.”

- Written by Jeremy Norman