Anomaly – Momentum vs. Contrarian Investing

Anomaly – Momentum vs. Contrarian Investing

Next on our list of stock market anomalies that lead to outsized performance, we’re gonna be talking about momentum vs. contrarian investing.

The question is this: should investors favor stocks that have outperformed the market or those that have lagged behind.

That answer depends on time horizon:

• Over short time horizons of about one month, momentum is negatively correlated with returns. Stocks that did well last month are likely to do poorly this month.
• Over medium time horizons of 2 to 12 months, momentum turns positive. Past winners continue to outperform.
• But over time horizons of 2-5 years, which is more applicable to most pre-retirees and retirees, momentum turns negative again. Past winners are more likely to be tomorrow’s losers.

So why do stocks that have outperformed the market over the prior year continue to excel over subsequent months? Three reasons stand out:

• Institutions have to scale in and out of positions slowly, which leads to momentum.
• Equity prices don’t immediately adjust to new information about a company. When a company beats earnings estimates, it typically continues to outperform in the days after the report. When a company misses, their stocks drift lower in the following days.
• In behavioral finance, there’s something called the disposition effect. It means that investors are reluctant to realize losses by selling a stock below is initial purchase price, but they’re quick to sell winning stocks in order to lock in gains. Because of that, stocks don’t get to their intrinsic value quickly…it takes time…and time leads to momentum.

Reach out today if you would like to discuss your momentum investing and other investment strategies with a financial professional.