Momentum strategies seek to buy recent winners and sell recent losers, exploiting persistent relative performance. The empirical importance of momentum as an asset pricing factor is established in academic research such as by Mark Carhart, University of Pennsylvania, who incorporated momentum into multifactor models. However, the pattern of strong average returns masks pronounced vulnerability during episodes of market stress.
Mechanisms behind underperformance
Several interacting forces explain why momentum tends to fail when markets turn. Liquidity shocks reduce the ability of investors to trade without moving prices, a dynamic documented in work by Yakov Amihud, New York University Stern, who links price impacts to returns through liquidity costs. When liquidity evaporates, previously crowded long positions face steep execution costs and wide bid-ask spreads, forcing incremental sellers to accept larger discounts. Behavioral models by Nicholas Barberis, Yale University; Andrei Shleifer, Harvard University; and Robert Vishny, University of Chicago Booth show how initially underreaction followed by overreaction creates momentum in calm markets and sharp reversals when information or sentiment shifts abruptly. Leverage and margin triggers amplify this process: funds using borrowed capital are forced to reduce exposure during drawdowns, accelerating selling into a falling market and generating large negative returns for momentum strategies.
Consequences and contextual nuances
The consequences are both financial and systemic. For investors, momentum drawdowns can be severe and occur when correlation across assets rises, reducing diversification benefits and increasing portfolio risk. For markets, crowded momentum trades can exacerbate price dislocations and strain intermediaries, with stronger effects in less liquid markets and regions where market microstructure and institutional depth are limited. Cultural and regulatory factors matter as well. In jurisdictions with frequent short-sale constraints or where retail participation is dominant, herding behavior can be more pronounced and unwind dynamics more damaging. Nuance matters: emerging markets often show larger liquidity gaps and greater sensitivity to capital flow reversals, while developed markets may absorb shocks more quickly but still suffer concentrated flows.
Awareness of these mechanisms suggests prudent risk management: stress testing for liquidity, position limits, dynamic risk controls, and combining momentum with defensive overlays can reduce vulnerability. Recognizing why momentum underperforms in stress clarifies both its long-run returns and the episodic nature of its risks.