Jason Wei and Liyan Yang at the University of Toronto tested the performance of various momentum strategies in US shares since 1964. They confirmed that the strategy of buying recent winners and selling recent losers generally does well. However, they found that there's one type of stock it doesn't work for – large, low-volatility ones. For blue chips, good performance in one three-month period tended to lead to poor performance in the next three. That's reversal rather than momentum.
There are two possible reasons for this. One is that investors have limited attention; they simply cannot follow all shares closely. This means that if a small stock does well it might continue to do so because its rise attracts investors' attention towards its merits. But this source of momentum doesn't apply to blue chips, which are closely watched anyway.
A second explanation has been suggested by economists at the University of Georgia – the idea of moderated confidence. This says that investors underreact to reliable signals but overreact to less reliable ones.
Imagine a small or volatile stock gets some genuinely good news. Investors might then underreact, believing that the signal is weak relative to the normal noise (volatility) surrounding the share. This underreaction will cause the share to rise too little in response to the good news, with the result that it drifts up later as investors cotton onto the share's better prospects.
But now imagine a blue-chip gets good news of similar magnitude. Investors might put lots of faith into this signal, believing it to be strong relative to the lower amount of noise accompanying the share. This can lead them to overreact, pushing the share price up to a level from which it subsequently falls.
In this way, volatile stocks underreact and so have momentum, while less volatile ones overreact and have reversals.
There are two lessons here for investors. One is that we should not be universal momentum investors. If large defensive shares do very well, we should not jump onto the bandwagon. Momentum works better for smaller stocks.
Secondly, all this corroborates the idea that momentum's profits have been a reward for exploiting other investors' cognitive biases rather than for taking risk in the conventional senses.
This, however, is a two-edged sword. There's a danger that momentum's success might disappear if or when investors wise up to these biases.