Understanding Momentum and Reversal Investing Strategies

Abstract

Momentum and reversals are two phenomena to explain the past return trend. Originally introduced by Jegadeesh and Titman in 1993, momentum is now a common investment strategy when investors are trading securities. It points out the stock price may have a relationship with their past performance. A large number of researchers have been trying to find out the momentum investment effect based on empirical evidence in different markets in different investment periods, which include short term, medium term and long term. Moreover, a series of research concludes that the momentum investment strategy tends to help investors to get a higher return. In recent years, a large number of researchers have focused more on analysing financial markets in China, and they have paid more attention to improving the traditional Jegadeesh and Titman models. In addition, an increasing number of researchers also point out that noise trading is quite important in the security investment strategy, and the investors who are using a momentum investment strategy to trade their portfolios are supposed to take the noise trading strategy into consideration. Then a series of papers have been tried to explain the sources of the momentum effect, either risk-based or behavioural-based. When it assumes that the market is efficient, the past market prices could be reflected, and it is hard to get excess returns by observing the stock's past prices performance. Nevertheless, the momentum effect is likely to examine that the market is inefficient. When it tries to explain the momentum effect in risk-based sources, the abnormal price return may be derived from a risk that is undiversifiable. As for the behaviour-based explanation, several behavioural biases applied by different researchers could be used to study the momentum effect, such as cognitive errors, including the conservatism bias, the representative bias, and the emotional bias, including the loss aversion bias, the overconfidence bias and the self-attribution bias. Another possible explanation within this behavioural source is that overreaction to the news leads to the existence of price momentum.