Overconfidence Could be Driving Momentum Investing

When momentum is on an investor’s side, serendipitous gains can accumulate, but it can also dangerously breed overconfidence or even an overreaction during mass sell-offs. They say in sports that speed kills, but in the markets, overconfidence or overreactions can blow up a trading account fast.

As the global economy begins to implement measures on re-opening, momentum has been a popular factor as equities are gaining steam behind a post-pandemic rally. With the help of federal governments and central banks, equities have been riding a nice wave of momentum, but that can easily turn the other way as investors saw in March during the sell-offs.

March’s sell-offs would constitute an overreaction as opposed to overconfidence. It’s difficult to avoid the herd mentality when investors are feverishly rushing for the exits amid a mental cacophony of “Sell, sell, sell!”

“Overreaction ultimately can lead to a reversal, but this scenario has become less common, and the reversals in recent decades have generally been less severe than before 1980,” a Wall Street Journal article, by Avanidhar Subrahmanyam and Sheridan Titman, said. “One reason is improved and accelerated disclosure of information by companies. Another is the increase in reports by market analysts. In general, anything that increases the extent to which information becomes public reduces the tendency of skeptical investors to react to stale information and generate a delayed overreaction.”

“The overconfidence and skepticism of investors also explains the tendency of stock prices to drift following corporate announcements like profit and revenue surprises, share repurchases and new equity issues,” the article added. “That’s because many investors tend to be skeptical even of the value of information that comes straight from a company, and that skepticism stretches out the effect of the positive news.”

If investors think that momentum can continue in a post-COVID market environment, one ETF that investors can look at is the iShares Edge MSCI USA Momentum Factor ETF (BATS: MTUM), which has been yielding gains of over 23% YTD according to Morningstar performance numbers. The fund seeks to track the investment results of the MSCI USA Momentum Index.

The fund generally will invest at least 90% of its assets in the component securities of the underlying index and may invest up to 10% of its assets in certain futures, options and swap contracts, cash and cash equivalents. As far as the index goes, it consists of stocks exhibiting relatively higher momentum characteristics than the traditional market capitalization-weighted parent index, the MSCI USA Index, which includes U.S. large- and mid-capitalization stocks.

For more market trends, visit ETF Trends.