Markets are efficient. People are not. There is a profit to be had in the disconnect between the two.

For the better part of the last 30 years, conventional investment wisdom has been governed by the so-called efficient markets hypothesis. It states that the broad stock market cannot be beaten on a consistent basis because all available information is built into stock prices. (For background reading, see Working Through The Efficient Market Hypothesis.)

Believe In The Market's Healthy Skepticism

How To Protect Investments From Cataclysmic "Fat Tails"

How To Profit From Other Investors' Mistakes

Following the logic of efficient markets, the best way to invest in U.S. stocks is the passively managed index approach. That means owning mutual funds that closely track the S&P 500 index, or the total market index like the Vanguard Total Stock Market Index Fund (VTSMX) and Schwab S&P 500 Index Fund (SWPPX), or exchange traded funds like the U.S. SPDR S&P 500 ETF Trust (SPY) and the Russell 1000 Index Fund (IWB).

On paper, this makes a lot of sense. After all, prices already represent the best collective estimate of value among all the players active in the market. Logical, right?

Not so fast. The theory ignores one crucial element: human emotion. It is humans that drive investment decisions, and we humans are not ourselves always driven by logic.

In fact, we humans are so consistently illogical that our illogic itself is very predictable. For attentive investors, that's good news. By studying other investors' recurring patterns of irrational behavior, it is possible to build an investment strategy that profits from the inherent lack of efficiency in markets that are driven by humans.

The heart of this approach to investing is momentum, or the tendency of winners to keep winning and losers to keep losing relative to their peers. This results because people tend to take great pleasure in holding onto their winners perhaps longer then they should. Also because investors tend to hang onto their losers a little longer then they should as well, because they don't want to lock in losses by selling. Just like Newton's first law of motion, which posits that objects in motion will stay in motion, stocks on a winning streak often tend to stay on a winning streak until they reach highs well above their fundamental values. Likewise, stocks on losing streaks tend to sink lower than an unemotional assessment of their inherent values would indicate they should.

This behavioral phenomenon is the result of the representative heuristic, or the "law of small numbers." Based on a limited perspective, investors mistakenly conclude that companies realizing extraordinary earnings growth today will continue to experience extraordinary earnings growth in the future. That certainly would seem to explain at least in part the upward momentum behind stocks like Google (Nasdaq:GOOG) and Amazon.com (Nasdaq:AMZN).

By applying this backward-looking perspective to forward-looking expectations, investors tend to overestimate positive signals and push prices of winners beyond their intrinsic values. The same pathology takes over when a company is showing negative earnings growth.

In fact, this pattern occurs so frequently that research by Narasimhan Jegadeesh and Sheridan Titman found that by applying an investment strategy to the momentum phenomenon, investors could earn returns of about 1% per month, which is a significant premium to the standard market results. This analysis has been found in over 40 markets globally and not just the U.S.

According to Gerstein Fisher's own research, in 45% to 50% of all U.S. actively managed growth funds that actually manage to beat the market, it is a tilt toward owning momentum stocks, as well as smaller companies and value stocks over the market weights, that accounts for most or all of returns in excess of the market's.

To isolate the impact of the momentum derived from behavioral factors, value and market caps on real-world market performance, Gerstein Fisher applied a factor-based regression analysis to almost 750 actively managed growth funds between October 1999 and September 2009. The analysis allowed us to isolate the individual variables that contributed to fund manager outperformance.

According to our findings, 82% of large-cap growth fund managers and 75% of small-cap growth fund managers outperformed their relevant market benchmarks over the decade studied. However, if you strip away the out-performance that resulted from above-average exposure to the risk factors studied (largely momentum), only 39% of large-cap growth managers and 36% of small-cap growth managers outperformed the benchmark.

Put simply, much of what appears to be fund manager "skill" is merely high exposure to momentum and other risk factors.

How can investors profit from this phenomenon? Perhaps the most important consideration when looking to take advantage of momentum investing is to access it as part of a more comprehensive, structured investment strategy. History shows that over the long term investors tend to be compensated with returns in excess of the market's average in exchange for assuming certain types of excess risk. Richly priced momentum stocks, which run the risk of tumbling back toward their long-term earnings multiples, are one such example.

Other types of stocks that likewise tend to compensate investors well over time are small caps and value stocks, which tend to be characterized by both higher volatility and higher long-term returns than the market as a whole. The best approach is for investors to seek exposure to all these risk factors. Investors who diversify their holdings broadly, while tilting toward these risk factors, can improve their chances of earning reliable returns over time.

Related Articles
  1. Mutual Funds & ETFs

    Top 5 Natixis Funds for Retirement Diversification in 2016

    Discover five mutual funds from Natixis Funds that provide high income, growth and preservation of capital while diversifying a retirement savings plan.
  2. Mutual Funds & ETFs

    4 Mutual Funds You Wish You Could Include In Your 401(k)

    Discover four mutual funds everybody wishes were in their 401(k)s. Learn which five-star-rated no-load funds leave their competition in the dust.
  3. Mutual Funds & ETFs

    Top 3 Allianz Funds for Retirement Diversification in 2016

    Discover the top three Allianz funds for retirement diversification in 2016, with a summary of the portfolio's managers, performance and risk measures.
  4. Mutual Funds & ETFs

    3 PIMCO Funds Rated 5 Stars by Morningstar

    Learn about three fixed income mutual funds managed by Pacific Investment Management Company (PIMCO) that have received five-star overall ratings from Morningstar.
  5. Mutual Funds & ETFs

    3 Invesco Funds Rated 5 Stars by Morningstar

    Learn about the top three mutual funds administered and managed by Invesco Ltd. that have received a five-star overall rating from Morningstar.
  6. Mutual Funds & ETFs

    The Top 4 Russell Funds for Retirement Diversification in 2016

    Discover four mutual funds administered and managed by Russell Investments that would add diversification benefits to a retirement portfolio.
  7. Mutual Funds & ETFs

    The 3 Best American Funds for the Income Seeker in 2016

    Learn about American Funds' mutual fund offerings, their past performance compared to peers and three American funds to consider for income investors.
  8. Term

    How Market Segments Work

    A market segment is a group of people who share similar qualities.
  9. Active Trading

    Market Efficiency Basics

    Market efficiency theory states that a stock’s price will fully reflect all available and relevant information at any given time.
  10. Mutual Funds & ETFs

    5 Low Fee Lord Abbett Mutual Funds

    Learn about five low expense ratio Lord Abbett mutual funds and the key characteristics about each mutual fund's top holdings, returns and total assets.
RELATED FAQS
  1. How do I use Weighted Alpha to create a forex trading strategy?

    In foreign exchange or conventional security markets, weighted alpha is designed to help discriminate between different instruments ... Read Full Answer >>
  2. What is Fibonacci retracement, and where do the ratios that are used come from?

    Fibonacci retracement is a very popular tool among technical traders and is based on the key numbers identified by mathematician ... Read Full Answer >>
  3. What is finance?

    "Finance" is a broad term that describes two related activities: the study of how money is managed and the actual process ... Read Full Answer >>
  4. What is the difference between positive and normative economics?

    Positive economics is objective and fact based, while normative economics is subjective and value based. Positive economic ... Read Full Answer >>
  5. Are target-date retirement funds good investments?

    The main benefit of target-date retirement funds is convenience. If you really don't want to bother with your retirement ... Read Full Answer >>
  6. Do mutual funds require a demat account?

    A dematerialized account enables electronic transfer of funds. The account is used so an investor does not need to hold the ... Read Full Answer >>
Hot Definitions
  1. Socially Responsible Investment - SRI

    An investment that is considered socially responsible because of the nature of the business the company conducts. Common ...
  2. Presidential Election Cycle (Theory)

    A theory developed by Yale Hirsch that states that U.S. stock markets are weakest in the year following the election of a ...
  3. Super Bowl Indicator

    An indicator based on the belief that a Super Bowl win for a team from the old AFL (AFC division) foretells a decline in ...
  4. Flight To Quality

    The action of investors moving their capital away from riskier investments to the safest possible investment vehicles. This ...
  5. Discouraged Worker

    A person who is eligible for employment and is able to work, but is currently unemployed and has not attempted to find employment ...
  6. Ponzimonium

    After Bernard Madoff's $65 billion Ponzi scheme was revealed, many new (smaller-scale) Ponzi schemers became exposed. Ponzimonium ...
Trading Center