What Momentum Actually Is — And Why It Works
The most mocked idea in investing is also one of the most empirically supported. Buying stocks because they have recently gone up — and selling stocks because they have recently gone down — sounds like pure speculation. Decades of academic research and real-world performance data say otherwise.
Why This Matters
For most of investing history, momentum was dismissed as unsophisticated. Serious investors, in the Graham-Buffett tradition, bought beaten-down stocks and waited for the market to recognise their value. Buying strength rather than weakness looked, philosophically, like doing the opposite of everything the value tradition had established. Richard Driehaus changed this conversation. A practitioner, not an academic, he built his investment approach around a simple but heretical premise: "buy high, sell higher." His results — consistently exceptional over decades of managing capital — forced the investment community to take momentum seriously as a systematic investment strategy. The academic community caught up in the 1990s, when Jegadeesh and Titman published their landmark research showing that stocks that had outperformed over the previous 3–12 months continued to outperform over the following 3–12 months, on average, at rates that could not be explained by risk alone. This "momentum effect" has since been replicated across multiple asset classes, time periods, and geographies. It is one of the most robust documented anomalies in financial markets.
The Core Idea
Momentum works for reasons rooted in human psychology and institutional behaviour. The first driver is underreaction: when a company reports better-than-expected results, the market's initial response is typically insufficient. Investors anchor to prior expectations, analysts revise forecasts slowly, and institutions cannot immediately build large positions. The stock drifts upward as the full implications of the information are gradually incorporated — creating a persistent trend. The second driver is herding: as a stock rises and positive attention increases, more investors are attracted to it. Trend-following systems, momentum-based funds, and retail attention reinforce the move. This creates a self-sustaining trend that continues until the underlying fundamental improvement is fully priced or until a reversal catalyst appears. The third driver is institutional friction: large fund managers cannot quickly rotate into rapidly strengthening stocks. They must build positions gradually, creating sustained buying pressure over months rather than days. This mechanical buying maintains trends longer than pure information-processing would suggest. Momentum investing is not guessing which stocks will go up. It is the systematic identification of stocks with the strongest relative price performance — combined with evidence that the underlying business performance justifies the strength — and positioning in those stocks while avoiding the weakest.
Richard Driehaus's Perspective
“Driehaus was explicit about the philosophical inversion at the heart of momentum: "I believe far more money is made buying high and selling higher than buying low and selling high. I am convinced that the greatest investment opportunities for above-average returns come from stocks in dynamic uptrends." His point was not that price strength was irrelevant to fundamentals — he required fundamental justification for every position. It was that the evidence of that fundamental strength was often most visible in price before it was visible in financial statements.”
Richard Driehaus
A Real Example
Microsoft in the years following Satya Nadella's appointment as CEO in 2014 illustrates how momentum and fundamentals interact. The stock began showing strong relative performance as early evidence of the cloud transformation — Azure revenue growth, enterprise customer wins, cultural transformation — became visible to early observers. Momentum investors, responding to price strength and improving earnings revisions, bought aggressively before the full transformation was visible in financial statements. Those who waited for the value investor's "cheap on fundamentals" signal waited years — by which time the stock had already compounded dramatically. The momentum in the price was the market's early signal of the fundamental transformation.
The Common Mistake
The most dangerous mistake in momentum investing is abandoning a system at precisely the wrong moment. Momentum strategies experience periodic sharp drawdowns — when market sentiment reverses, momentum stocks (which have attracted the most recent buying) often fall faster than the market. Investors who adopt momentum strategies without fully internalising their drawdown characteristics panic at these reversals and exit, crystallising losses and missing the subsequent recovery. Momentum is a strategy that requires systematic discipline, not ad hoc judgment. The investor who applies it selectively — taking the winners but abandoning the system during losses — systematically buys the mistakes and sells the recoveries.
Key Takeaways
What to Read Next
The next lesson explores the CAN SLIM system — William O'Neil's framework for combining fundamental quality with technical timing to identify market leaders at the optimal moment of entry.
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The Core Worldview of Momentum Investing