We are fond of relative strength. It’s a solid investment method that have proven itself over a long period of time. Sure, it has its challenges and there are certainly periods of time during which it underperforms, but all-in-all it works and it’s been good to us. It’s always nice, though, when I run across another credible source that sings its praises. Consider the following excerpt from an article on the Optimal Momentum blog:
Momentum, on the other hand, has always made sense. It is based on the phrase “cut your losses; let your profits run on,” coined by the famed economist David Ricardo in the 1700s. Ricardo became wealthy following his own advice. [Editor's note: We wrote about this in David Ricardo's Golden Rules.] Many others, such as Livermore, Gartley, Wycoff, Darvas, and Driehaus, have done likewise over the following years. Behavioral finance has given solid reasons why momentum works. The case for momentum is now so strong that two of the fathers of modern finance, Fama and French, call momentum “the premier market anomaly” that is “above suspicion.”
Momentum, on the other hand, is pretty simple. Every approach, including momentum, must determine what assets to use and when to rebalance a portfolio. The single parameter unique to momentum is the look back period for determining an asset’s relative strength. In a 1937, using data from 1920 through 1935, Cowles and Jones found stocks that performed best over the past twelve months continued to perform best afterwards. In 1967, Bob Levy came to the same conclusion using a six-month look back window applied to stocks from 1960 through 1965. In 1993, using data from 1962 through 1989 and rigorous testing methods, Jegadeesh and Titman (J&T) reaffirmed the validity of momentum. They found the same six and twelve months look back periods to be best. Momentum is not only simple, but it has been remarkably consistent over the past seventy-five years.
Momentum, on the other hand, is one of the most robust approaches in terms of its applicability and reliability. Following the 1993 seminal study by J&T, there have been nearly 400 published momentum papers, making it one of the most heavily researched finance topics over the past twenty years. Extensive academic research has shown that price momentum works in virtually all markets and time periods, from Victorian ages up to the present.
Of course, momentum is just the academic term for relative strength. For more on the history of relative strength—and how it became known as momentum in academia—see CSI Pasadena: Relative Strength Identity Theft. The bigger point is that relative strength has a lot of backing from both academics and practitioners. There are more complicated investment methods, but not many that are better than relative strength.
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