Do You Believe in Momentum?

Momentum is a “strength or force that keeps growing or building.” You can think of momentum as the tendency for things to continue moving in a particular direction. Sometimes momentum is obvious, while other times it’s hard to distinguish from pure chance. How you think about momentum can influence how you think about investing.

One clear example of momentum is physical fitness. The more you put into it, the more you trend in a positive direction. When I bike all summer, I get better at biking. Then winter happens, and by April I’m pretty much starting from scratch again. Academic research suggests that habits compound, like interest. Small improvements repeated daily can create dramatic long-term effects. I think of this as positive momentum.

p = mv

But momentum is sometimes hard to distinguish from statistical randomness. Many people believe in winning streaks and losing streaks in sports. One of my favorite movies growing up was the baseball classic The Natural, with Robert Redford. As the hapless team stumbles its way through a streak of losing games, a psychiatrist visiting the team remarks, “losing is a disease, as contagious as bubonic plague. Attacking one but infecting all.” The team eventually turns around the momentum, culminating in a Roy Hobbs pennant-winning home run that shatters the stadium lights.

But what if winning and losing streaks are just statistical oddities? Imagine you flip a coin 10 times. There is an infinitesimally small possibility that you will get 10 heads in a row—about one in 1,000. But if you flip the same coin 5,000 times, it is a near guarantee that you will have at least one streak of 10 heads in a row.

Some argue that baseball streaks are similarly random. With so many teams playing so many games, there is a reasonable likelihood that teams will produce lengthy winning and losing streaks at random.

That brings us to investing (you knew I’d get there eventually). Some professional investors and academics believe that prices “have no memory.” What happened today, this month, or this year has no bearing on what was going to happen in the next day, month, or year. In other words, winning or losing streaks in an individual stock or the entire market might be nothing more than statistical randomness, like flipping 10 heads in a row. The pattern of a stock price is a “random walk.”

But there is also empirical evidence that momentum exists in stock prices. Research shows that stocks that perform well in the short term often continue to do so, a pattern traditional models can’t explain. The best explanation for why momentum might exist in stock prices is likely a behavioral one: Investors tend to chase what has recently done well.

Momentum is one of the most puzzling anomalies in finance. How you feel about momentum might be a key determinant of your investment personality.

As someone who likes data and analytics, I’ve always been drawn to fundamental investing. This is the idea that you can estimate a stock’s “fair value” by analyzing financial metrics. Fundamental investors (or value investors) look for companies that are priced below their fair value.

Fundamental investors tend to believe that prices have no memory. These investors are more likely to be contrarian—buying stocks that are declining rather than looking for those with positive momentum. This is how Warren Buffett and countless other classic investors built their fortunes.

Thinking this way means you look for deals when stocks fall. But this investment style can also lead to anxiety after periods when stocks have risen for several months in a row, as they have recently done. When you think this way, you may be inclined to sell stocks as the market rises. This has always been my inclination, since I studied fundamental analysis and I’m always looking for a good deal.

But being a good investor requires us to test our own assumptions and stay alert to our own biases. The best investors are aware of their current environment. In the last several years, momentum has been a driving force in stock market returns. Value stocks have done well, but growth stocks—especially those with the highest momentum—have outperformed. The market has been powered higher by companies with the most growth and momentum, not by companies that were “too cheap.” There is nothing inherently wrong in being a value or a growth investor, and both can be successful, but growth investors have done better in the last decade.

The U.S. stock market continues to grind upward, driven by these large stocks with the best momentum. Other risky assets such as gold and Bitcoin also seem to have positive momentum. For those of us who are value investors, this requires a different way of thinking about momentum.

Momentum surrounds us—in our habits, in sports, and in markets. Sometimes it’s real, sometimes it may just be randomness wearing a convincing disguise. For investors, the challenge is to avoid choosing sides blindly and recognize when momentum is driving returns and when fundamentals matter most. Understanding your own beliefs about momentum can be a helpful starting point for developing this more nuanced investment approach.

This article originally appeared in The Berkshire Eagle.