Momentum and Reversal

Two puzzling patterns in stock returns - recent winners keep winning for a while, while long-term losers tend to rebound - and their behavioural explanations.

If markets were perfectly efficient, past returns wouldn’t predict future returns. But researchers have found two persistent patterns.

Momentum

In 1993, economists Narasimhan Jegadeesh and Sheridan Titman found that stocks that performed best over the past three to twelve months tended to keep outperforming over the following months, while the worst performers kept underperforming. This is momentum.

Momentum has been found in many countries and asset classes, including in India.

Long-term reversal

In 1985, Werner De Bondt and Richard Thaler found the opposite over longer periods: stocks that had performed worst over the past three to five years tended to do better in the following years, while past winners did worse. This is long-term reversal.

Behavioural explanations

Underreaction: investors adjust slowly to new information, so good news keeps pushing prices up for a while, creating momentum.
Overreaction: over longer periods, investors become too optimistic about winners and too pessimistic about losers, so prices eventually reverse.
Herding can amplify trends.

Rational explanations

Some economists argue these patterns reflect risk: momentum strategies can suffer sudden crashes, and past losers may be riskier firms. The debate between behavioural and risk-based explanations continues.

Can investors profit?

Momentum funds and factor ETFs exist, including in India.
But momentum strategies involve high turnover, costs and occasional sharp crashes, such as in 2009 when past losers rebounded rapidly.
After being widely published, some anomalies have weakened as investors exploit them.

The lesson

Markets show patterns linked to human behaviour, but exploiting them is harder than it looks. For most investors, understanding these patterns is more useful for avoiding mistakes than for trading.

The trending stock

A company reports better-than-expected profits. Its share price rises, but analysts and investors revise their views gradually, so the price keeps drifting up for months. Years later, after too much optimism, the stock underperforms as expectations prove too high.

Thinking patterns in returns are guaranteed profits

Momentum and reversal exist on average, but they involve costs, risks and crashes, and may weaken over time.

Key takeaways

Momentum: recent winners tend to keep winning for three to twelve months.
Long-term reversal: three-to-five-year losers tend to rebound.
Underreaction and overreaction offer behavioural explanations.
Exploiting these patterns involves costs, risks and crashes.