There is an old saying on Wall Street: “The trend is your friend.”
Simply put: a stock that outperformed its peers over a certain look-back has a higher probability of repeating that in the future, and vice versa (relative momentum). The second effect is called “absolute momentum.” A stock in an uptrend is expected to stay in an uptrend, and vice versa.
There is strong academic evidence for both effects in a broad range of assets and different geographical markets. These effects are based on the fact that markets are not perfectly information efficient (slow diffusion of information), herding behavior, and the over-and-under reaction of investors.
The chart above shows a simple trend-following strategy that has been applied to the S&P 500 for over a 100-years-worth of data (no dividends, no transaction costs). Figures reveal a much better risk-adjusted return (Sharpe ratio), higher return, less risk and less maximum drawdown for the trend-following strategy compared to the passive buy-and-hold approach. Under realistic assumptions (transaction costs, execution, etc.), the difference wouldn’t be this big, but it would still be substantial.
✓ Former hedge fund portfolio manager/trader
✓ 15 years of experience in financial markets
✓ Master of Science (MSc) in Business and Economics from the University of Basel
✓ Developed quantitative tools for an asset management