Recognizing an Investing Signal That Defied Wisdom, and Endured

Stock market investing gurus have dispensed maxims like “buy low, sell high“ and “what goes up must come down, and vice versa,” or Eugene Fama’s “efficient markets hypothesis,” which assumes that the price of a security reflects all relevant and known information about that asset. But those guideposts have never convincingly explained why some stocks seem to keep rising or falling on their own steam, or what is called “momentum investing.”

The inexplicability of that phenomenon led to a pivotal 1993 research paper titled “Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency,” by Narasimhan Jegadeesh, chair of the finance department at Emory University, and Sheridan Titman, chair of the department of financial services at the McCombs School of Business at the University of Texas at Austin.

In September, nearly three decades after the Journal of Finance published the paper, Jegadeesh and Titman were awarded the Wharton-Jacobs Levy Prize for Quantitative Financial Innovation at the Jacobs Levy Center’s conference in New York City. The Wharton-Jacobs Levy prize, endowed with a $2 million gift, has been presented biennially since 2013.

The prize attempts to capture the cumulative effect of financial innovation from peer-reviewed research in terms of its long-term effects in the practice of financial management and also in triggering further academic research. The paper spawned numerous follow-up research papers that explored different facets of momentum investing, including one in 2020 by the original authors.

Significance of the Paper

Jegadeesh and Titman found in their research that when investors use trading strategies that buy past winners and sell past losers, they realize significant abnormal returns; their findings covered the 1965-1980 period. They proposed two interpretations of their results: One was that transactions by investors who buy past winners and sell past losers move prices away from their long-run values temporarily and thereby cause prices to overreact. Alternatively, it is possible that the market underreacts to information about the short-term prospects of firms but overreacts to information about their long-term prospects, they stated.

Jegadeesh and Titman are being honored for their work in “documenting the momentum premium,” said Bruce Jacobs, principal and co-founder at Jacobs Levy Equity Management Center, as he awarded them the prize. He noted that economist Robert J. Shiller of Yale University had called their work “a bombshell paper” in a 2015 New York Times article. “That paper found that stock prices aren’t really a random walk, as had been previously theorized, but that prices of individual stocks do tend a bit to continue in a direction initially set, for a matter of three months to a year,” Shiller had written.

“The paper can be summed up with a simple set of instructions: ‘Buy stocks that have performed well and sell stocks that have performed poorly,’” Jacobs continued. “Jegadeesh and Titman’s findings seem to contradict much of what we thought we knew about investing, including the efficient market hypothesis, the Random Walk theory, the capital-asset pricing model, and even [the] buy low, sell high [maxim].”

According to Jacobs, the model that Jegadeesh and Titman articulated is “elegant in its simplicity, [and it] describes a factor of unusual strength and robustness.” He noted that subsequent studies have shown that momentum has produced return premiums in and out of sample in dozens of countries and asset classes for hundreds of years. “While we’re not close to understanding why stock price momentum persists, this is part of the beauty of our honorees’ work. By shining a bright light on classical beliefs about how markets work, they have challenged us and themselves to gain a deeper understanding of stock price behavior so that our theories better reflect market realities. In the meantime, their momentum model has provided skilled practitioners with a tool for improving investor outcomes.”

The paper “challenged the conventional notion of buy low, sell high, sparking significant additional research and a shift in the strategies used by fund managers,” said Wharton dean Erika James.

Kenneth Levy, also principal and cofounder at Jacobs Levy Equity Management, traced the history of momentum investing to the 18th century and pointed out that “19th and early 20th century investment manuals often recommended what we now call momentum strategies.” Despite that, momentum investing as a strategy “never neatly fit into the late 20th century world of efficient markets and modern portfolio theory,” he added. But Jegadeesh and Titman “have shown us how it could be applied systematically by skilled practitioners,” he noted.

‘A Simple Signal’

According to Jegadeesh, their paper offered investment practitioners “a simple, positive, profitable signal.” After the publication of the paper, momentum investing became more widely used; academics also became interested because it came at a time when the “efficient market hypothesis” was considered well-established. “Here is a set of simple strategies that seems to [enable investors to] make huge profits, and we listed out all the strategies we considered.” The next step was to try and explain the phenomenon in various ways, which triggered many other research papers, which Jegadeesh described as “data mining risk and behavioral explanations.”

Titman recalled his disbelief when he first saw the findings of their research. “When I think about this paper, I go back to the old joke on the economist seeing the $20 bill on the sidewalk and walking by and saying, ‘That’s obviously not a real $20 bill, otherwise someone would have already picked it up.’ That was my initial thought when we were looking at the original momentum results,” he said. “We have a lot of financial economists and people in the investment world trying to find a strategy that’s simple, that makes money. How could it possibly be that there’s something this simple and this straightforward that’s existed for this long? It’s still a good question. Even after 30 years, there’s a lot that we’re still learning.”

“A lot of investors think about the law of gravity – once it goes up, it has to come down,” said Jegadeesh. “Hopefully, [our paper] would enlighten them to the idea that it’s not always [that] what comes down goes up and what goes up comes down.”

Momentum from Different Perspectives

Panelists at the conference had varying definitions of momentum investing. Yale finance professor Tobias Moskowitz said that momentum can be explained by the phenomenon where “stocks or any asset that does better than its peers over some prior period of time tends to predict relative performance in the future.”

Kent Daniel, professor of business in the finance division at Columbia University, referred to the “price continuation” of a stock that occurs with “underreaction or continuing overreaction” to information, followed by a long-term reversal of returns. “Momentum is the middle-horizon phenomena,” he added. Mark Carhart, chief investment officer at Kepos Capital, said that as an asset manager, he defined momentum “as any predictability where you’re buying assets that are going up and selling assets that are going down.”

Jegadeesh said that after the publication of their paper, he assumed that “a lot of people will rush in and eliminate the profits.” But that did not occur, as it happened. “The fact that it persists may just mean that it’s riskier.”

Christopher Geczy, Wharton finance professor and the academic co-director of the Jacobs Levy Center, also wondered whether momentum is a risk factor, in part because of its persistence. Carhart agreed with Geczy that momentum is a persistent phenomenon, but said he didn’t care if it was a risk factor.

Geczy persisted with his question. “We have to care [about whether momentum represents risk] because the prices that investors pay for beta versus alpha or something in between are vastly different,” he said. Carhart laid out what he considered interesting to him as an investor: “Is there predictability in returns that we can use to improve performance? Secondly, are there ways to do performance evaluation to better explain, manage your performance and distinguish between luck and skill?”

Moskowitz noted that “it’s not easy to arbitrage away” the momentum phenomenon. “All of us have lived through multiple momentum crashes – they’re painful, they’re rare, they’re deep, they cause people to give up,” he said. “Being able to weather that storm is certainly a risk to somebody.”

Levy noted that “the benefits of momentum can disappear suddenly and for extended periods,” adding that “this may point to a risk-based explanation.” He referenced a 2011 follow-up paper by Jegadeesh and Titman, where they argued that the magnitude and persistence of momentum returns are too strong to be explained by risk. “Instead, many see momentum as the result of investors being slow to react to new information – in other words, to underreact, causing prices to adjust slowly but persistently,” Levy continued. “An alternative explanation is that investors overreact to new information, pushing prices up or down.”