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Momentum Trading

According to efficient market hypothesis, share prices at any time incorporate all known information. Hence their next move could easily be up or down - 'random walk', regardless of how they have performed recently.

But a research from London Business School, sponsored by ABN Amro, suggests that a stock's course is as random as that of a boulder rolling down a hill. Using data going back to 1900, they identified a distinct 'momentum' effect: over time, each year's big winners would the next next year continue to beat the previous year's big losers.

The cumulative effect of an aggressive strategy that forever took the previous year's 20 best performing UK stocks (out of the top 100) is extraordinary. Since 1990, this strategy would have beaten a portfolio of each year's 20 worst losers - stocks with negative momentum - by an average of 10.27% points each year.

Stock market of Brussels

Stock market of Brussels (Photo credit: Wikipedia)

The phenomenon was found throughout the developed world's stock markets throughout the 20th century. The only time momentum strategies have lost money in the US is 2000 - tech bubble burst. Last year, despite the turmoil, this strategy would have made 32% in the US. However, it should be noted that that with trading costs included, the century's cumulative returns would reduce by more than half.

The implication is if one were to trade heavily, always picking the latest hot stock, history would suggests it would make money.

Source:  Financial Times, John Authers, 2008-02-14, “Momentum Trading