The search for an investment strategy that will yield consistently high abnormal returns has long been sought for by academic researches and market professionals.
While momentum strategies are not intuitive (Why should a stock keep on rising just because it has done so far ?)these strategies are among such strategies as the January effect or week end effects that have proved over time to yield high abnormal returns (such that to contradict market efficiency assumptions).
Using momentum strategies is quite simple and requires no use of judgment on the part of the investor. According to this strategy buying stocks which have performed well and selling short stocks which have performed poorly in the past would yield high abnormal returns. The underlying assumption being, of course, that these stocks would continue to perform as they have for a certain period of time in the future.
An example of the use of a momentum strategy would be: Firstly to sort the returns of the 100 top NYSE stocks for the last 12 months in descending order. then to buy the top 10 performers and sell short the bottom 10 performers for a period of 3 months. Selling the stocks short would finance the purchase of the top performing stocks. The period in which to evaluate the stocks or hold them may change (usually 3-12 months) to yield higher abnormal returns.
A more complex version of momentum strategy is demonstrated in Jegadeesh and Titman’s “Returns to buying Winners and Selling Losers: Implications for Stock Market Efficiency” (1993). In the article the writers examine a momentum strategy in which the investor updates the portfolio every selected period.
The relative success of this strategy is often attributed to over (or under) reaction to information. New information which would lower or raise the stock’s price in a perfect market has an enduring effect thus creating momentum for an extended period of time. Another explanation might be under valuations of stocks by analysts. Analysts tend to over valuate a stock’s past performance thus as the under valuation is revealed the stocks tend to perform even better as a result of the previous under valuation.