Investor memory and the momentum effect

Quick: List all the good investments you made last year. Now list all the bad investments you made last year.

If you are like most people, it will have been much easier for you to remember the good investments than the bad investments, and most likely your list of good investments will be longer than your list of bad investments. 

That is not too surprising, since we tend to be overconfident in our abilities as investors and have a natural tendency to “forget” or rationalise bad decisions in the past. In fact, if you want to become a world-famous stock market pundit it helps to have selective amnesia where you constantly remind everyone of the one correct forecast you made in the last ten years while conveniently forgetting the dozens of incorrect forecasts you made as well.

However, Katrin Gödker and her colleagues have published a report last month that sheds some new light on our selective memory as investors. They asked investors to participate in a laboratory experiment where they could choose between a safe investment and a risky investment. The risky investment was a simplified stock investment and could either have a 60% chance of a positive return and 40% chance of a negative return or vice versa. What they wanted to test is how well investors remembered the performance of their investments a week after they made them and how that would influence their investment decisions in subsequent trials.

The interesting result of their experiment is that investors tended to remember positive outcomes from their stock investment more readily than negative outcomes. This effect led them to choose a risky stock market investment with a negative skew (i.e. a 60% chance of a loss vs. a 40% chance of a gain) even in those cases when choosing a safe investment would have been the better alternative. However, this “memory bias” to remember mostly the positive outcomes could not be measured when the participants in the experiment only made paper trails and did not invest money in the stocks. In other words, as soon as we have “skin in the game” in the form of invested money, our memory may become more biased – something that might lead to worse performance in the future simply because we may increasingly overestimate our ability to select profitable investments. 

Furthermore, this memory bias might explain a curious phenomenon in the persistence of momentum effects. Michael Cooper and his colleagues described in 2004 how momentum effects in the stock market persist for a long time during a bull market but fade quickly in a bear market. The researchers tested the performance of stocks in months one to twelve after a three-year bull market as well as the performance of these stocks in months twelve to 60. Three years into a bull market the usual momentum effect could be observed with stocks showing positive monthly performance in the first twelve months and reversion to the mean (i.e. negative performance) in the months after that. After a three-year bear market, however, the picture was different. In this environment no momentum effect could be observed and gains from a momentum strategy were negative independent of the time horizon. 

The study on memory bias might explain why this is the case. Because we more readily remember past winners, we keep investing in stocks that have shown positive returns in the past. This creates consistent buying pressure, particularly for those stocks that have done well in a bull market. As a result, the memory bias drives stocks higher and higher levels. In a bear market, however, our bias towards forgetting negative past performance means that investors are quickly willing to buy into stocks that have lost money in the past, creating demand for stocks that have declined and thus reversing the momentum effect in bear markets. 

After ten years of a bull market in global stock markets this needs to be kept in mind as market returns decline. Momentum investing has become a fashionable exercise in recent years because it has worked so well during the bull market and advocates of momentum investing claim that it should continue to work in a bear market as well. And while it may well create outperformance in a bear market as well as a bull market, it seems this outperformance may well be much smaller than the outperformance over the last ten years.

Momentum gains in bull and bear markets

Source: Cooper et al. (2004).