Frogs, momentum and investment

Author: Chris Dillow

It's well known that momentum investing has paid off well. What's not so well known is why. Two recent papers provide two very different explanations.

Zhi Da at the University of Notre Dame says it's because investors have limited attention; they simply cannot monitor all news about all shares. This means that they don't pay enough notice to gradual small pieces of good news about particular stocks, and so they under-react to such news. They are like the (apocryphal) frog in a pan of water. It doesn't notice that it is gradually heating up, with the result that it fails to act and so scalds to death - except that the lack of action has happier consequences for investors than for the frog.

He tested this theory by measuring the gradualness of news, based simply upon shares' daily returns. And he found that stocks whose good news arrives gently and gradually earn stronger and longer momentum profits that stocks whose good news comes in a single lump.

There's a simple implication here. Investors should look out for shares which, over a few months, enjoy many days of modestly good returns. These are more likely to do well subsequently than stocks whose good performance is due to one piece of good news. Last month's big fall in De La Rue, after the hoped-for takeover by Oberthur fell through, shows that it's dangerous to trade on momentum that's based on just one story.

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