When and Why Does Momentum Work—and Not Work?

Abstract

With a history of empirical success, momentum became widely adopted by investment managers despite a lack of consensus on why it worked. Then in the 2000s, momentum failed, with negative returns and sharp downturns. This article examines behavioral, market friction, and risk-based explanations for why momentum works. The author also pinpoints several circumstances when momentum fails, including post-decimalization, after bear markets, during volatile markets, and when value stocks outperform. He discusses how the three explanations of momentum’s behavior enable us to understand why momentum has failed and applies these conditions to understand momentum’s failure during the 2000s. This article thus provides guidance into when and why momentum works or doesn’t work, which will help investors decide how to proceed going forward. TOPICS: Security analysis and valuation, analysis of individual factors/risk premia, legal/regulatory/public policy, exchanges/markets/clearinghouses, performance measurement Key Findings ▪ The success of momentum can be explained by a variety of behavioral, market friction, and risk considerations. ▪ Under certain conditions, momentum will tend to not work, including post-decimalization, after bear markets, during periods of volatility, and when value stocks outperform. ▪ These conditions were more prevalent in the 2000s, helping to explain momentum’s weak performance in those years and providing investors with guidance going forward.