How momentum trading can go wrong
Buying winning stocks and betting against losing ones could be a poor strategy in a fast-rebounding market
- Momentum traders buy rising stocks and sell those that have been falling, believing that past price movements predict future prices. This strategy has produced consistent returns, but it is also prone to rare, sudden crashes, according to Chicago Booth’s Tobias J. Moskowitz and Columbia Business School’s Kent D. Daniel.
- These crashes tend to occur when a bear market suddenly ends, market volatility is high, and stocks dramatically rebound. In such environments, last year’s losers perform well while the winners lag—the opposite of what a momentum trader would be betting on.
- A momentum crash occurred when the US stock market bottomed out in March 2009. Over the next three months, the worst-performing US stocks in the past year gained 156 percent, while the best-performers increased by 6.5 percent. Gains by former losers extended throughout the following year (see chart).
- The effect of the stocks’ beta, or sensitivity to market swings, could be driving momentum crashes. Stocks that fall with the market may be more tied to market movements than those that perform well. Consequently, the return on a momentum portfolio that is long on past winners and short on past losers drops as the market recovers.