Perhaps the strongest deviation from the simplest textbook theory of market efficiency is the success of momentum investing. For example, my no-thought momentum portfolio (comprising the 20 biggest rising stocks in the previous 12 months) has outperformed the FTSE 350 by 9.1 percentage points a year over the last 10 years. This, of course, is no mere quirk. Good returns on momentum strategies were first spotted in US stocks by Sheridan Titman and Narasimhan Jegadeesh in 2001 and since then have been discovered in international markets as well as in commodities and currencies.
The success of momentum investing is therefore as robust a finding as we’re likely to get in noisy financial data. But why does it exist?
Professor Titman has a new theory: it’s a result of investors’ overconfidence.
This, he says, takes two forms. One is that (some) investors have more faith in their own beliefs than they do in others’. When good news about a stock arrives, overconfident investors who were sceptical about the company's merits sell as others buy. This causes the share to underreact initially to that good news and hence to rise later. This is consistent with post-earnings announcement drift – the tendency for shares to rise in the days following good results in violation of the efficient market theory’s prediction that such news should be immediately embodied in prices.
The second aspect is that traders who come late to a stock exaggerate their own knowledge and so believe a stock is underpriced even if it has risen a lot recently. This is likely to be the case if a share’s rise causes a company to attract the attention of investors who had previously ignored it.
Rational investors, says Professor Titman, cannot eliminate the mispricings caused by overconfident investors because they are risk-averse. This limits them in two ways. First, it makes them reluctant to pile into stocks they believe to have underreacted to good news because they don’t want to take big positions in individual stocks. And, secondly, they are afraid to short-sell stocks they believe to have risen too much. Short-selling is always risky because overpriced stocks can become even more overpriced in the short term which means than even if you are right in the long term, you might have to spend a fortune on margin calls before being vindicated.
So far we have a hypothesis. What about evidence?
One otherwise odd fact that’s consistent with this theory, say Professor Titman, is that momentum investing doesn’t work as well in Japan as in the US or the UK. This might be because of a cultural difference. Whereas Americans are brought up to be individualists, Japanese are raised to have more respect for the wisdom of groups. Japanese, therefore, are less likely than Americans to be overconfident.
There’s something else. If overconfidence explains momentum investing, we’d expect to see stronger momentum effects in shares that are harder to value because in such shares will be driven less by public information and more by individuals (mis)judgments. We’d also expect momentum to be stronger in stocks that are harder to short-sell. We should, therefore, see more momentum in (say) Aim stocks than in (say) utilities.
So do we?
One obvious test here is to see how the 10-month average rule works. This rule says we should buy when prices are above their 10-month average and sell when they are below it. This rule will work well when momentum effects are strong – when rising prices lead to further rises. But it will fail when high prices cause value investors to sell and the stock to fall.
And this rule does indeed work better for Aim stocks than for utilities. If you’d applied the 10 month rule at the end of each month since 1996 you would have made 6.6 per cent per year in Aim whereas a buy-and-hold strategy would have lost you 0.3 per cent per year. That’s a momentum premium of 6.9 percentage points. Applying the same rule to utilities, however, would have made you only 5.2 per cent per year, a percentage point less than a buy-and-hold strategy. (This ignores dividends and assumes a zero return when we are out of the market.)
This suggests that momentum effects are stronger in stocks that are hard to value. Which is what we’d expect to see if overconfidence drives momentum.
Of course, this is suggestive rather than conclusive. And there are other possible explanations for momentum – such as investors simply underreacting to good news or to them not paying full attention to stocks enjoying such news. But it is at least possible that there’s a link between overconfidence and momentum.
