n the last two months, you would have made more money by betting on previous stock market losers than on winners. This is the exact opposite of the well-known “impulse effect” expected by Wall Street.
Although this reversal was partly caused by temporary factors related to the new bull market, which started at the end of March, it also reflects more lasting market changes that could greatly reduce the progress of the profitability effect.
That would be a major change to what was once one of Wall Street’s most lucrative strategies. Since 1926, a portfolio of the best-performing stocks for the past year has performed much better than a second portfolio containing the worst-performing stocks, with a margin of 10.6 percentage points a year, according to data from Ken Frans, a professor at Dartmouth.
However, this historical model has been reversed since March 23 this year (the bottom of the stock market), and according to the study, the low-momentum portfolio since then until the end of April has given a higher return than a high-rate portfolio – a difference of 10.7% . And keep in mind that this difference in performance is not annual, as the advantage of shares with low momentum for this period is over 70%.
At least in part, this reversal was to be expected, as momentum usually fails in the first few months after the bottom of the bear market. When the economy begins to recover, the best performing stocks will be those companies that were otherwise close to certain bankruptcy bets.
Recent research suggests that longer-term market change may also play a role. At the same time, this study found that the inertial effect is largely caused by the behavior of retail investors and that they represent a smaller and smaller share of total trade.
The study “Behavior of small investors around news and the effect of inertia”, which has been distributed since February in academic circles, gives an idea of some facts from the investment decisions of speculators. Its authors are Cheng Luo, a leading scientist at Farallon Capital Management, Enrichetta Ravina, a professor at Northwestern University in the United States, and Luis Viceira, a professor at Harvard Business School. The researchers came to their conclusions after analyzing the trading decisions of 2.8 million individual accounts of a large brokerage company from 2010 to 2014.
They find that, in general, individual investors react contrary to surprises from companies’ income statements. That is, they tend to sell shares that have had a positive surprise and buy shares with a negative surprise. Their behavior leads to impulsive movements because it means that stocks underestimate their surprises for the reports. As the market eventually corrects this decline, stocks with a positive surprise continue to gain and those with a negative surprise continue to lose.
This aspect of human behavior is not new. What is changing is the decreasing part of the trade volume compared to the above factor. Because of this, researchers say, the effect of impulsive movements decreases.
And this is exactly what we see, as illustrated in the diagram at the top of this article. It shows the difference in the average 20-year return on stocks with the highest and lowest momentum, but there is a clear downward trend over the past four decades.
The returns shown in this chart do not take into account transaction costs. As traders trading on the momentum strategy undergo many transactions, it is quite possible that after transaction costs, high-impulse stocks will not enjoy a real advantage over low-rate stocks over the last 20 years.
There are at least two main investment implications of this study. The first is that you may need to lower your expectations for inertial approaches in the coming years. The second is that you should not automatically bet that the market reaction based on a surprise from the income statement will soon be reversed.
Junior Trader Radi Djuma