Peter Lynch ran the Fidelity Magellan fund from 1977 to 1990 with resounding success, posting 29 percent annualized returns and earning one of the best investing track records of all time. If investing had its own Hall of Fame, Peter Lynch’s tribute would likely be housed in the same section as Warren Buffett, John Templeton, and other investing greats.
Coincidentally, while Lynch’s Magellan fund earned 29 percent annually, the investors in his fund did not. Lynch pointed out the disconnect himself. By his own calculation, the average investor in Magellan made roughly 7 percent annually in the time he ran it. The reason was simple: when the fund suffered bouts of bad performance, investors redeemed shares of his fund. And after performance improved, investors returned, having missed the recovery.
The human tendency to buy good performance and sell bad performance has been around forever. But not all performance chasing is created equal. One area of investment that holds similarities to performance chasing but is backed by strong academic research is momentum investing. Gene Fama, the father of efficient markets, referred to momentum investing as “the premiere market anomaly.”
In its simplest form, momentum investing means buying stocks that have recently performed well and selling those that have performed poorly. The major differences between momentum investing and performance chasing is that momentum investing has a rules-based approach around buying and selling. Most momentum funds tend to rebalance at least semi-annually, so there’s a systematic process around getting in and out of positions.
In a sense, momentum investing attempts to take advantage of the human tendency to chase performance.
Additionally, momentum investing tends to be a short-term phenomenon. Research shows stocks that have performed well over the past six to 12 months should continue to perform well over the next six to 12 months.
Momentum is based on the premise that recent performance trends, not long-term trends, persist. One explanation for momentum’s success is that investors are slow to react to new information. The likely verdict is the lag in investor reactions causes prices to adjust slower to new information than they otherwise should, and that creates persistence in performance.
Disclaimer: Momentum strategies are designed to capitalize on the continuance of existing market trends. These strategies may experience more volatility than the market as a whole and could result in losses if market trends do not persist.