In acknowledgement of the lack of adequate risk-based explanations, even the father of the efficient market hypothesis, Eugene Fama, referred to momentum as the biggest challenge to his theory.īehavioral finance has been more successful at explaining the existence of the momentum factor However, research shows that risk-managed momentum strategies which do not exhibit crashes also have the potential to generate high returns for investors, clearly contradicting this theory. Indeed, it is known that momentum strategies can suffer from sudden and devastating crashes, such as the one that occurred in 2009.
However, real-world evidence suggests these components actually change slowly.Īnother risk-based explanation is that the momentum premium could arise from investors expecting to be compensated for potential crash risk. Therefore, from a risk-based perspective, the premium could stem either from the constant change in financial market risks or shifts in how much risk investors are willing to bear.
In practice, momentum is a fast-changing factor and the stocks it favors can change substantially from one month to the next. According to the neoclassical school of thought, the momentum premium is compensation for bearing some systematic risk.
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