Momentum is a market anomaly which many people have tried to explain but have not succeeded to a satisfactory extent. As to the source of momentum profits, others have tried to rationalize their origins whereas an opposing school of thought has searched for their origins in behavioural finance. In this paper I will explore the possible origins of momentum profits through highlighting the important aspects of both the rational and the behavioural field.
The Rational Approach to Momentum
Pioneering research by Jegadeesh and Titman (1993) find that past winners, (securities which historically performed well), continue to outperform the past losers, (securities that historically lost money), over horizons of three to twelve months. They also reached to the conclusion that this anomaly wouldn’t last forever and part of it would fade away gradually as the time goes by. For momentum to be rational, risk would have to increase for the winners and decrease for the losers over the ranking period. What would be expected from such a scenario is that the beta coefficient of the winning securities be lower than the beta of the loser securities. This is however to the contrary. In actual fact, the beta of the losers is lower and these loser securities carry less risk than the winning security.
The CAPM of Sharpe (1964) and Lintner (1965) has been the pillar of finance, studied in business schools globally. It establishes the link between risk and average return expected from a security, the risk of which is embodied in beta. Using CAPM, a high risk security would have a high beta and so a high average return is expected from the security. In this sense CAPM fails to explain momentum anomaly since it has been shown that winning securities have a surprisingly lower beta than the losers and yet have higher returns. The conclusion that none of the momentum payoff is due to systematic risk can be drawn. Fama and French’s 3 factor model expanded on the CAPM by ascertaining that other factors apart from risk also influence market returns. Namely by adding size, value and growth factors since CAPM is unable to capture return anomalies. The 3 factor model still fails to capture the momentum payoff evidence by Daniel & Titman’s (1997) criticism of the three factor model, indicating that it has no explanation for the long term effect and the momentum returns for the securities. Malkiel (2003) argues that achieving excess returns without increasing the risk would be considered impossible as price rapidly adjusts to new information. The conclusion that none of the momentum pay-off is due to systematic risk can be drawn..
The efficient market hypothesis of Fama (1970) maintains that all stocks are perfectly priced according to their inherent investment properties, the knowledge of which all market participants possess equally and there is no way to earn excess profits, (more than the market overall), by using this information. Assuming investor’s rationality, security markets were believed to be efficient in fully reflecting all publicly available information, without any delay, (Malkiel, 2003).The efficient market hypothesis is rejected on the basis of investor irrationality. That is to say how investors tend to under/overreact to information, which Jegadeesh and Titman (1993) argue may be the source of momentum profits. There is also the assumption used by EMH that stock prices are unpredictable, but in actual fact stock prices have proven to be somewhat predictable so this violates one of the premises of the efficient market. Therefore where investors are irrational, the market is inefficient. EMH therefore fails in giving an explanation for the momentum payoff.
Conrad and Kaul (1998) showed that the cross-sectional variation in the mean returns of individual securities included in the momentum strategy plays an important role in its profitability. The cross-sectional variation can potentially account for the profitability of momentum strategies and it is also responsible for attenuating the profits from price reversals to long horizon contrarian strategies. Fama and French (1992) concluded that the combination of size and BE/ME performs best in explaining the cross-sectional variation in stock returns and that when these two factors are accounted for, CAPM beta becomes insignificant
It should also be noted that the state of the economy at a point in time, business cycles and company life cycles can have an impact on momentum profits. These conditions further give evidence of disproving the rational nature of momentum profits.
The Behavioural Approach to Momentum
The propensity of investors to act in an irrational manner when processing information as well as investor expectations regarding the future leads to an inefficient market and this is the premise of the behavioural origin of momentum profits. Investors are likely to underreact to new information that comes out and is public knowledge and are likely to overreact to new private information that becomes available to them. In this way they will make inordinate returns without taking on further risk. Barberis, Shleifer and Vishny (1998) defined under-reaction as an increase in average returns due to the good news and a decrease caused by the bad news. Over-reaction will thus lead to contrarian profits in the long term, whereas under-reaction will lead to momentum profits in the short term. Investors thus act emotionally, being influenced by predilection, taste, beliefs etc. when it comes to investing. Momentum can thus be caused by the speed at which investors react to information. Insiders are overconfident and over react to the private information. Then gradually and as the private information becomes public, prices will be adjusted. So prices seem overreact to public information. This temporary overreaction will be traduced by the momentum effect. (Zholgami and Faten 2003)
A causal link between momentum and risk based theories has not been firmly established and hence a behavioural cause seems more than likely. More research into momentum origins needs to be done and possibly new models need to be developed to explain them, but my personal opinion leans to the more psychological roots since humans, by nature, are irrational.
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