Momentum vs Mean Reversion

Two opposite ideas that both show up in markets, at different time scales. Knowing which one you are betting on is half of any strategy.

In short
  • Momentum: recent winners keep winning for a while, most often over 3 to 12 months.
  • Mean reversion: extreme moves partly reverse, over very short and very long periods.
  • A variance-ratio test shows which one dominates in an index's own history.

Momentum

Stocks and sectors that did best over the past 3 to 12 months have tended to keep doing better for the next few months. This pattern, documented in academic research since the 1990s (for example Jegadeesh and Titman, 1993), is the basis of momentum indices and trend-following.

Mean reversion

Over very short periods (days to a few weeks) and very long ones (several years), extreme moves have tended to partly reverse. A stock that fell sharply last week often bounces; a sector that lagged for five years can recover as valuations reset.

How to test it

A variance ratio compares how far an index moves over several weeks with how far it would move if each week were independent. Above 1 means moves tend to continue (trend); below 1 means they tend to reverse. The Edge Scanner runs this test on every NSE index: since 2016, small and mid-cap indices showed a trend character, while over the last three years most indices looked close to a random walk.

Common mistakes

  • Mixing time frames: a momentum view over months and a bounce view over days can both be right.
  • Assuming the pattern is permanent. Character changes with the market.
  • Using a test on too little data.

Common questions

What is momentum investing?

Buying what has risen the most over the past several months, on the evidence that relative winners have tended to keep doing better for a while.

What is mean reversion?

The tendency of extreme moves to partly reverse towards an average, seen most over very short and very long periods.

Which works better in India?

It depends on the time frame and period. Since 2016, momentum over months showed up clearly in small and mid caps, but no pattern holds all the time.