The previous post concerned momentum - a strategy of buying past times winners as well as selling past times losers. It discussed how this strategy does good on average, only on rare occasions (recent marketplace downturns as well as high marketplace volatility) does real poorly.
Another argue why momentum may perform poorly is because other investors are chasing the same strategy. One of the "behavioral" explanations for momentum is underreaction, as well as goes equally follows. Suppose a fellowship experiences skillful news, which increases its truthful value past times 10%. However, the stock cost may alone ascent past times 6%, because (a) alone roughly investors notice the news, due to express attending - they follow hundreds of stocks, as well as cannot notice what happens to every unmarried stock on a item day, and/or (b) investors produce notice the news, only convey stubborn prior beliefs - an investor may convey a long-standing belief that the stock is of low-quality, as well as may cling to this belief fifty-fifty subsequently receiving the news.
Regardless of the explanation, momentum works. You should purchase a fellowship that has risen past times 6% over the past times half-dozen months, because its truthful value has increased past times 10%, as well as then it may make the in conclusion 4% over the adjacent half-dozen months.
However, what if all investors mean value similar that? Then, they may pile into a stock that has risen past times 6%. This extra buying pressure level causes it to ascent roughly other 5% - then that the full increment is straightaway 11% as well as then it has overshot. How does a would-be momentum investor ensure that he hasn't bought a stock that has overshot?
Christopher Polk as well as Dong Lou of the London School of Economics written report this inquiry inwards an interesting newspaper entitled "Comomentum". The persuasion is equally follows. If investors are trying to exploit momentum (causing stocks to overshoot), they would convey piled into many past winners, as well as equivalent sold many past losers. Then, the stock returns of past times winners volition covary amongst each other (i.e. movement upward together), as well as similarly the stock returns of past times losers volition covary amongst each other. They innovate a novel measure, comomentum, which is the abnormal correlations amidst past times winners as well as past times losers - the stocks the momentum trader volition merchandise on. When comomentum is high, this suggests that lots of investors are piling into momentum trades, as well as then the trades are less profitable.
Indeed, they honor that their comomentum mensurate significantly predicts the futurity profitability of momentum. The effects are economically large. When comomentum is inwards the summit 20% of its range, the momentum strategy earns 10.4% lower returns inwards its offset twelvemonth than when it is inwards the bottom 20% of its range. Simply put, when comomentum is high, other investors are pursuing the momentum strategy. This strategy is straightaway crowded, then you lot should larn out.
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