Study validates momentum investing. But does real life?

Momentum investing generated a huge advantage over the general markets according to the study

Last week, there was this news about a study by three researchers at the London Business School on the efficacy of momentum investing, with The Economist writing a major article about it.

A group of researchers ran a hypothetical investment strategy over more than a hundred years of stock price data and found that momentum investing generated a huge advantage over the general markets, the advantage being more than 10% per annum.

Already, there has been a spate of news stories, blog entries and discussions about how this study validates momentum investing. Identifying momentum stocks and investing in them, that is, the standard punting method employed by most traders now supposedly stands vindicated.

In reality, this study does nothing of the sort. There's momentum and there's momentum. The method used in the study for momentum investing actually bears not even a passing resemblance to what your common or garden variety momentum trader actually does. The researchers ran what was basically a 100-year passive investing strategy based on momentum.

Their method of following momentum was that they stayed invested in the 20 stocks that had performed the best over the previous one year. This portfolio was rebalanced every month. Every month, they calculated afresh which were the 20 best stocks over the preceding twelve months and shifted the investments to those 20.

The idea is simple--stocks that are rising will keep rising, at least for a while. Beyond deciding on this algorithm, no human intervention was made to the portfolio. This was basically an index fund of momentum investing. The strategy makes no attempt to try and figure out why the momentum was there, or even make any assumptions about it.

In sharp contrast, real-life momentum trading generally consists of identifying momentum stocks and hypothesising which momentum will last and which won't. It's just punting on rumours, nothing more.

-- Dhirendra Kumar