Continuing the streak of writing about the most prominent academic research papers on finance and investment, today I will write about “Returns to Buying Winners and Selling Losers,” which was published in 1993 in the Journal of Finance and is currently the third most highly quoted paper in history.

The authors, Narasimham Jegadeesh and Sheridan Titman, studied whether there is persistent money to be made by buying winners and selling losers, otherwise known as the momentum strategy. If the answer is yes, what is the best way to execute it? 

They found that if one buys a portfolio of winners (stocks with the top decile returns in the previous 12 months) and sells a portfolio of losers (stocks with the bottom decile returns in the previous 12 months), and holds that for 3 months, one can achieve a return of 1.49% per month on paper. This is huge! This level of monthly returns translates into nearly 18% annual return. 

Throughout my 20 years of giving financial advice, I have noticed that amateur investors love momentum strategy, while more mature investors shun it because they have learned the caveats.

So what are the caveats?

Jegadeesh and Titman’s own research shows that the momentum effect lasts only up to a year. In the second and third years, the winner portfolio actually underperforms the loser portfolio! The momentum effect is the strongest in the first three months after portfolio formation.

To take advantage of the momentum effect, one must trade their portfolio frequently, leading to high portfolio turnover. As we learned in my most recent newsletter “How to Pick Mutual Fund Winners,” based on another highly quoted research on mutual fund performance, high turnover of a portfolio decimates returns.

The Tax implication

On top of that, high turnover also means that one must pay the much higher short-term capital gains tax rate on their profits as opposed to the lower long-term capital gain tax rate. 

Tendency to sudden reversal

Subsequent studies of the momentum strategy also reveal that momentum stocks are prone to sudden reversal which can cause huge losses. 

When all of these caveats are factored in, the momentum strategy is not likely to be a persistently profitable one.

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