What Works on Wall Street Chapter 3: The Importance of Momentum

"Investors should buy stocks that have already begun to rise. Stocks that have performed well over the past six to twelve months tend to continue to perform well in the near future." — James O'Shaughnessy

The Investment Context

While the data proved that Value investing works over the long term, O'Shaughnessy found a problem: cheap stocks can stay cheap for a very long time. This is known as a "value trap." A stock might be trading at a massive discount, but if no one cares, it will just sit there for five years doing nothing.

To solve this, O'Shaughnessy tested another factor: Momentum. Momentum is the tendency of winning stocks to keep winning, and losing stocks to keep losing, in the short-to-medium term (6 to 12 months).

The Wall Street Translation

Traditional value investors (like Warren Buffett in his early days) often ignore momentum, believing that price charts are irrelevant. O'Shaughnessy's data proves that ignoring momentum leaves massive amounts of money on the table.

1. The Psychology of Momentum: Momentum exists because humans are slow to react to new information (the "anchoring" bias). When a company releases a surprisingly great earnings report, the stock price goes up, but investors don't immediately drive it to its true fair value because they anchor to the old price. It takes 6 to 12 months for the market to fully absorb the new reality, creating a steady upward trend.
2. Relative Strength: O'Shaughnessy measured momentum using "Relative Strength"—how much a stock's price went up over the last 6 months compared to the rest of the market. Buying stocks with the highest 6-month relative strength dramatically improved returns.
3. The Catalyst: Momentum acts as the catalyst for value stocks. It signals that the broader market has finally realized the stock is too cheap and has started buying it.

Actionable Trading Rules

1. Don't Catch Falling Knives: Never buy a stock just because it is cheap, especially if the price is in a massive downtrend. A stock dropping from $50 to $10 might look like a bargain, but the momentum is violently negative. Wait for the bleeding to stop.
2. Wait for the Turn: If you find a deeply undervalued company, put it on a watchlist. Do not buy it until the 6-month price chart shows a clear uptrend. You want to buy the bargain after other investors have started bidding it up.
3. Sell the Losers: If you own a stock that has severely underperformed the broader market for the last 6 to 12 months, the data says it will likely continue to underperform. Cut your losers; do not hold them hoping for a miracle.