Do Past Returns Predict Future Returns? Evidence from Momentum and Short – Term Reversals
The weak form of the Efficient Market Hypothesis1 explains that stock prices reflect all available information, and that past price movements should be unrelated to future average returns. Contrary to that theory, academic research by Narasimhan Jegadeesh and Sheridan Titman suggests that prior movements in price are related to expected stock returns. Specifically, Jegadeesh (1990) finds evidence of short-term reversals, or stocks that have risen relative to the rest of the market in the past month underperform those that have fallen relative to the rest of the market. Jegadeesh and Titman (1993, 2001) find evidence of momentum in stock returns, or the tendency for stocks that have outperformed the market over the past year to continue to outperform when compared to stocks that have underperformed over the previous year. These two phenomena, while related, reflect how movements in past stock prices predict expected returns over different horizons: Short-term reversal focuses on returns over the previous month, while momentum focuses on returns over the past three months to one year. To avoid confounding effects, momentum is often measured skipping the most recent month, t-1, or using data from months t-12, t-11, t-10…t-2.
In this article, we consider the practical implications for momentum and short-term reversal investment strategies. When evaluating whether a factor that reflects a particular firm characteristic such as past one-year return (momentum) or past one-month return (short-term reversal) is relevant for portfolio construction, the following criteria may be useful:
- Are these investment strategies robust and do they explain differences in average stock returns across countries, industries, and different time periods?
- How do these investment strategies explain differences in expected returns, and do we expect these return premia to persist in the future?
- What are the tax and turnover implications for these investment strategies?
- How should each investment strategy be used to complement other factors in the portfolio?
In our view, short-term reversal and momentum strategies reflect genuine return premia that can benefit an investor if implemented in a way that does not substantially increase portfolio turnover.