To survive in the stock market, you should generally be highly skeptical about the existence of seemingly surefire ways to “beat” the stock market. There are two reasons that most "easy money" schemes fail: the first is that the anomalies are often not real, the second is that the anomalies are real, but they do not continue in the future.
Why the Promise of Easy Money is So Often a Scam
There are two good reasons to treat any promise of easy money with an extra dose of skepticism when it comes to the stock market.
First, there are tens of thousands of smart and highly paid professionals that are constantly searching for easy ways to make money, and it is unlikely that one of us will stumble across something they have missed. Institutional investment firms often hire graduates from the top universities and business schools in the country and give them virtually unlimited trial and research budgets and unparalleled access to senior management teams. These advantages are just tough for the individual investor to overcome. So if you think you have found something they have missed, be cautious.
Second, examining past stock market returns for patterns creates a huge danger of "data mining" errors, or of scouring the data to find a relationship that might not actually be significant. This is a significant danger because there is an entire cottage industry that exists to attempt to find market anomalies, so it is very likely that researchers occasionally stumble upon a relationship that looks significant but is actually just a result of random processes (for more see "What Data Mining is And Why You Should Be Concerned About It").
To really believe in an "anomaly" you need to develop a theory of why the anomaly has persisted in the past. If you have no way to explain what you are seeing, then you might just be picking up noise.
Why Even Real Anomalies Are Generally Unlikely To Persist in The Future
There is a curious property of markets that make any attempt to exploit market anomalies highly dangerous: markets are adaptive .
If a surefire way to make money is found and published, then profit-seeking traders and investment managers are likely to seize on it and start using it to manage their own money. This will have the effect of pushing the prices of securities that meet the criteria up.
Imagine that a professor somewhere has written a paper conclusively showing that stocks beginning with the letter “X” out-perform, perhaps because investors have shunned them in the past as a result of their hard-to-pronounce names. Well if this news got out to the market, traders would see the potential to make an easy excess return and immediately place buy orders for “X” stocks. This would push the price of the “X” stocks up as many would be trying to purchase them at the same time. But a higher price implies lower future returns, so the anomaly would likely quickly go away, almost immediately.
Why Momentum Is Likely To Persist Anyway
So is momentum likely to quickly go away now that everyone knows about it? It is always possible, but there are a couple reasons to think not.
One is that momentum has been known about for some time, both by traders who have lived by the adage “the trend is your friend” long before any Finance professors were writing papers about momentum, and by academics, who have been writing about the topic since at least the early 1990s. Thus far, knowledge of a momentum anomaly does not seem to have made it go away.
The second reason is that we actually can explain momentum in the light of institutional and human tendencies that are unlikely to change in the future.
Momentum can be explained through two seemingly contradictory statements: security prices are slow to adjust to new information, and security prices overreact to new information. You can think about the dot com “bubble” as a nice stylized example: a new phenomenon (“the internet”) came along and disrupted the existing paradigm, and people eventually massively overreacted to this and bid prices up to absurd levels. Each of these factors – an initial under-reaction to new information, and an eventual overreaction, have a set of institutional causes and a set of psychological causes, neither of which is likely to disappear anytime soon.
Why prices may be slow to react to new information
- Institutional Reasons: Given their large positions, institutions cannot move quickly without moving the market. Large institutional investors can have enormous positions in a stock, in some cases owning more than 10% of a company. There are not enough shares traded every day for them to instantaneously adjust these positions without dramatically impacting the price. Let's look at a real example: the largest mutual-fund shareholder of Underarmour (UA) is the Fidelity Contrafund, which owns almost 6% of it, or 4.8 million shares. But the average daily volume of Underarmour is only 1.9 million shares. So there is no way Fidelity could get out of the position overnight without flooding the market with Underarmour share and sharply lowering the price.
- Psychological Reasons – Numerous academic studies have shown that we all have a strong need to maintain a sense of internal consistency. This makes us subject to what behavioral economists call “confirmation bias.” Studies show that when given a set of data which contains a mix of positive and negative data about the probability of a future event, the majority of people will conclude that the data set supports their pre-existing view, and do so in a way that is apparently subconscious (i.e. they are not away that they are selectively picking data). When people have been forced to state their view in a public setting (such as a Portfolio Manager who purchases a stock for his mutual fund), this effect is even greater, with barely anyone able to view new information in an unbiased manner. Since markets are composed primarily of human beings making qualitative judgments, this suggests that it is likely that new data that countervails a prevailing view will initially be greeted with much skepticism, making prices slow to react. In other words, not everyone will “catch on to” new information at the same time.
Why prices may tend to eventually overreact to new information
- Institutional Reasons - Professional investment managers face “career risk” and do not want to miss out on key trends. The vast majority of investors continue to be measured in relative terms, against a benchmark. The professional-management industry can also be a short-term world, and a pressure cooker – a few bad quarters and people will think they you have lost your “touch”, and you can lose assets and even lose your job.
- Psychological Reasons - People are naturally subject to "herding." This should come to no surprise to anyone who has ever observed the group dynamics of just about any mass of people. But most people might fail to realize the impact that is can have on security prices. When a great "story" - be it .com stocks, housing prices, or Apple, it is just impossible for many people to resist "buying in" when so many others are getting rich around them.
It is never good to be complacent when it comes to investing, and we need to acknowledge that it is hard to predict how the dynamics of the capital markets might change in the future. It is very possible that momentum strategies will not always continue to “work,” or (perhaps more likely) that they might work over different time scales in the future. We will continue to track these developments very closely. But in the immediate future the prospects for momentum seem bright, as its institutional and behavioral underpinnings will likely remain unchanged, and it will be difficult for institutions to arbitrage its effects away anytime soon.
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