Momentum is one of the most overlooked factors in all of investing.

Stocks that have performed well in the past usually continue to perform well in the future. When put this way, it seems rather obvious.

But, thanks to a few cognitive biases, no one invests this way.

And therein lies the opportunity.

Why momentum investing works

Emotion, not logic, moves the markets.

At one point or another, all investors have made a decision based on emotions. Most emotion-based decisions occur around large drops in price (fear) or after large increases in price (greed). But these aren’t the only times our emotions get the best of us.

In a groundbreaking paper, Daniel Khaneman et al. found that stock prices frequently overreact or underreact to new information. Of course, it wasn’t the stock prices themselves that were overreacting or underreacting but the investors who were trading them.

Since Kahneman’s research, additional studies found that:

1. Buying past winners and selling past losers realize significant abnormal returns (source),

2. The momentum phenomenon has been persistent and significant since at least 1801 (source), 

3. Momentum trading strategies are profitable even after adjusting for market capitalization and book ratio (source), and

4. Momentum strategies are still profitable even after adjusting for transaction costs (which are even lower now than when the study took place) (source).

While all four of these studies reaffirm the existence of the momentum premium, none do much to explain why it exists. For that, we turn back to Kahneman.

Kahneman, a former psychology professor at Yale, won a Nobel Prize for his work in behavioral economics. According to his research, there are two main cognitive biases investors suffer from which may be the root cause of the momentum premium.

• Anchoring Effect: Investors rely on the first piece of information they receive, like an initial stock price. “Anchored” to this initial number, investors tend to underweight new information. This leads investors to think things like Nvidia can’t be worth $900 per share since it was worth just $400 per share less than a year ago, regardless of the business’s underlying fundamentals.

• Prospect Theory: Investors are disposed to sell their winners and hold their losers, despite obvious reasons to do the opposite (the stock price rose because it is a good stock to own). If the fundamentals support it, Nvidia may in fact be a better investment at $900 per share than it was at $400.

Together, these two biases create a large mental hurdle investors need to overcome to hold or buy stocks whose prices have appreciated, regardless of how strong the reasons for their appreciation (such as improving fundamentals). Since almost all investors suffer from this mental hurdle, the best stocks are frequently undervalued by the market, leaving additional room for future price appreciation.

This creates the opportunity to invest based on momentum.

Common criticisms of momentum investing

1. “Once a stock’s price has appreciated, it is no longer a good buy.”

This is the most common objection to momentum investing.

As already discussed, investors underreact to new information and are anchored to old prices. They’re also more likely to sell a stock that has appreciated than a stock that has remained flat or underperformed. This thinking is wrong.

We associate higher prices with riskier and more expensive investments, and frequently fail to properly account for improving fundamentals. But higher prices are exactly what we should expect.

The stocks we invest in should be growing revenue, profit, and margins over time. As the fundamentals improve, the company should continue to become more valuable, which will be reflected in an increasing stock price.

Higher stock prices are typically a signal of strong businesses performing well.

2. “I prefer value investing.”

Value and momentum are not on opposite ends of a spectrum. Rather, they’re two sides of the same coin.

For example, when we added Powell Industries (POWL) to the portfolio on 5/15/2023, the stock had appreciated 56% YTD. However, on the selection date, it traded at a lower earnings multiple than it had to start the year (screenshot below). This is because, although the price had increased, earnings had increased more.