Mellody Hobson: Shining A Light on Momentum Investing

Since 2013, the FAANG stocks—Facebook, Amazon, Apple, Netflix, and Alphabet (a.k.a. Google)—have grabbed headlines, and for good reason. In the past five years, this collection of tech behemoths has seen their stock prices shoot up anywhere from 121% to 663%. These five companies have a combined market cap of nearly $3.3 trillion. The extent to which they have reshaped the way we live is hard to overstate.But it is not just our lives that they have shaken up. Their recent stock performance can also help us understand a phenomenon called momentum investing.

John Waggoner of best defined this strategy when he wrote, “In its simplest form, momentum simply means buying whatever is going up the most, and selling it when it loses steam.” Put another way, momentum measures how much a stock’s price has gone up or down relative to others over some time period—typically 12 months. Investors who embrace this approach operate under the premise that stocks that have performed well recently will sustain their positive trajectory, while those that have fared poorly over the same period will continue to do so.

When it comes to the momentum approach: the value of a stock is not solely determined based on the company’s underlying fundamentals. Instead, behavioral psychology plays a significant role. Recency bias causes people to expect recent performance will continue indefinitely. As a result, investors anchor to past stock prices, rather than adjusting based on a company’s fundamentals. Overreaction then follows, as the cycle becomes self-reinforcing and herd mentality takes over. Finally, confirmation bias—our desire to favor information that confirms our own beliefs—leads us to continue to support the trend, regardless of what the full data set is telling us. Together, these behavioral biases can lead investors to stray too far from traditional performance metrics and put themselves at the mercy of the crowd.

Indeed, while momentum can do well over sustained periods of time, there are inflection points whereby its performance can reverse dramatically and wipe out entire years of gains. Because momentum investing can get swept up in mania, there are considerable downside risks. As the famed value investor Howard Marks notes in his new book, “What’s the greatest source of investment risk? . . . [I]t comes when asset prices attain excessively high levels as a result of some new intoxicating rationale that can’t be justified on the basis of fundamentals and that causes unreasonably high valuations to be assigned.” None of this a critique of FAANG companies. They are incredibly successful businesses. But their recent market success shines a light on an investing strategy that can harm investors who have a fear of missing out. Remember, momentum does not only go in one direction.