Momentum, reversion and risk

We have spoken about reversion, or losers outperforming winners. This approach works. In their 1985 paper ‘Does the stock market overeact?”, DeBondt and Thaler explained the idea of mean reversion and how it leads to the Loser’s portfolio of three years outperforming the Winner’s portfolio of the same time. Findings of reversion in stock prices towards some fundamental values remain in literature for a decade. DeBondt and Thaler [1985] using overreaction showcased that a stock experiencing poor performance over a three to five-year period subsequently tend to outperform a stock that had previously performed relatively well. This implies that, on average, stocks which are ‘losers’ in terms of returns subsequently become ‘winners’ and vice versa. This is the reversion strategy.

In another paper written by Narasimhan Jagadeesh and Sheridan Titman in 1993, the authors illustrate returns to buying winners and selling losers. The conclusion of the paper states “Trading Strategies that buy past winners and sell past losers realise significant abnormal returns”. The paper studies the momentum strategy comprehensively but focuses on the behavioural aspect, i.e. what investor behaviour causes the superior returns to happen in the year following the portfolio formation data and then the returns dissipate within the following two years.

Both these papers are highly cited and are considered significant in Behavioural Finance. Thaler and Kahneman were awarded Nobel Prize in 2002 for their work. However, despite such path-breaking work, application of the work is limited. Were the Behavioural Finance practitioners more concerned about the behavioural aspects in the investment business than about investment strategies? Is this the reason why we never had a study on this conflict between momentum and reversion? The contradiction in market suggests it is profitable buying winners and selling losers and vice versa.

We are not aware of research addressing this conflict between the two papers (between momentum and reversion). Unlike the 1985 paper where the authors illustrate overreaction as a reason for losers delivering positive returns vs. winners (reversion), the 1993 paper illustrates positive returns buying winners and selling losers (momentum) and uses the pattern to challenge investor underreaction.

Now, one may wonder how both momentum and reversion work together. These are two mirroring strategies, which deliver profit at the same time. Why is it important to resolve this conflict? Two mirror strategies working together at the same time could be a key insight about the structure of the markets. Answering why the conflicting strategies work and when they work would help visualise the big picture.

Let’s try to explain why there is reality on both sides of the mirror. Market is a large group of traded assets. Assets move up and down in ranking. When an asset becomes top ranked (positive and negative outliers), they get prone to reversion (1985 Paper). Outliers don’t happen every day. This is why mean reversion is known to work on larger cycles of three years. The rest of the time, it’s all momentum. Till the time a stock does not reach an outlier status, the winner continues to win and vice versa. This is why some time profits are about “buying winners and selling losers” and sometime profits are about “buying losers and selling winners”. And since a stock or an asset can’t be at two places at the same time i.e. be an outlier and consistent winner at the same time, investors can execute two strategies simultaneously. They can buy a winning asset that continues to perform and sell a positive outlier, which is ready to underperform and fall. This explains why momentum and reversion can work together.

Housing Development and Infrastructure Limited (HDIL) was the worst ranking Jiseki India stock we have been mentioning as an accumulate and buy along with DLF, Reliance Communications, Punj Lloyd, Suzlon, Reliance Power and BSEPOWER. Guess what? All of them have outperformed NIFTY since the start of the year. These are classic examples of reversion. Tata Motors and TCS are top momentum contenders continuing to outperform. Now the tough part is to understand when the momentum stock changes character. This is why we need to integrate momentum, reversion and risk.

The author is CMT, and Co-Founder, Orpheus CAPITALS, a global alternative research firm