Forget "Buy Low, Sell High": The Stock Market's Real Secret Is Buying Winners!
A Groundbreaking 1993 Study Uncovers the Unconventional Strategy That Consistently Outperforms the Market – And Challenges Everything You Thought You Knew About Investing.
This old study, still works
For decades, the investing mantra has been simple: "buy low, sell high." This often translates into "contrarian" strategies – picking stocks that have recently performed poorly in the hopes of a rebound, and selling those that have soared, anticipating a correction. Indeed, some academic research, notably by De Bondt and Thaler (1985, 1987), suggested that such contrarian approaches could yield abnormal returns over long horizons due to stock price "overreaction".
However, a pivotal 1993 study by Narasimhan Jegadeesh and Sheridan Titman, titled "Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency," revealed a surprising truth that defied much of the prevailing academic wisdom. They found that the exact opposite strategy – what's known as a relative strength strategy – consistently generated significant profits.
The Unconventional Truth: Buying Winners Works!
Jegadeesh and Titman rigorously documented that strategies which buy stocks that have performed well in the past and simultaneously sell stocks that have performed poorly in the past generate significant positive returns. This profitability was observed over 3- to 12-month holding periods for NYSE and AMEX stocks between 1965 and 1989.
Consider these striking findings from their research:
The most successful "zero-cost" strategy – buying past winners and selling past losers – involved selecting stocks based on their returns over the previous 12 months and holding them for 3 months. This strategy yielded an impressive 1.31% per month.
Even simpler approaches, like basing selections on 6-month prior returns and holding for 6 months, generated about 1% per month. This specific 6-month/6-month strategy, examined in detail, realized a compounded excess return of 12.01% per year on average.
The profitability was robust: nearly all the "zero-cost" portfolios examined yielded positive and statistically significant returns. In fact, introducing a one-week lag between the portfolio formation and holding period often led to slightly higher returns, suggesting that these profits aren't just fleeting, short-term price pressures.
Dispelling the Myths: Why These Profits Are Unique
The brilliance of the Jegadeesh and Titman study lies not just in documenting these profits, but in meticulously investigating why they occur. Their conclusions directly challenge common explanations for market anomalies:
It's Not About Systematic Risk: The study definitively showed that the profitability of these relative strength strategies is not due to systematic risk. Counter-intuitively, the zero-cost portfolio (winners minus losers) actually exhibited a negative beta, meaning it moved inversely to the market. If the profits were due to systematic risk, we'd expect higher risk to be compensated with higher returns, not the other way around. Furthermore, their risk-adjusted returns remained significant, primarily driven by the strong positive abnormal returns of the past winners (the "buy" side of the strategy).
It's Not About Delayed Reactions to Common Factors (Lead-Lag Effects): Another common theory for market inefficiencies is that some stocks react with a lag to broader market movements or common factors. However, the researchers found that their profits could not be attributed to delayed stock price reactions to common factors. The serial covariance of the market index itself was found to be negative, which would actually reduce these profits if a lead-lag effect were at play. This critical finding steered their conclusion towards a different source of market inefficiency.
The Real Explanation: Underreaction to Firm-Specific Information
So, if it's not systematic risk or common factor lead-lags, what drives these persistent profits? Jegadeesh and Titman's evidence is consistent with delayed price reactions to firm-specific information. This means that when positive news about a company comes out, the market might not fully incorporate its implications immediately, leading to a prolonged positive price trend. Similarly, negative firm-specific news might lead to a delayed downward drift.
However, the story isn't entirely straightforward, and this is where the study provides nuanced insights into market behavior:
Temporary vs. Permanent Profits: While the strategies generated significant positive returns in the first 12 months after portfolio formation, the researchers observed an "inverted U" shape in cumulative returns. Roughly half of these excess returns dissipated over the following two years. This suggests that the initial price changes are at least partially temporary.
Shifting Risk Profiles: While the risk of the portfolio did change over time, it did so in a way that counteracted explaining the profit pattern, further discrediting a risk-based explanation for the observed returns.
Beyond the Averages: Practical Considerations
The study also delved into various practical aspects and market nuances:
Transaction Costs: Even after accounting for a conservative 0.5% one-way transaction cost (with an average semiannual turnover of 84.8%), the strategy still yielded a robust risk-adjusted return of 9.29% per year. This suggests its viability for institutional investors.
Seasonality: The strategy consistently lost money in January (around -7% on average), a well-known market anomaly. However, it performed strongly in all other months, particularly in April, November, and December. The April performance, in particular, was remarkably consistent, yielding positive returns in 96% of Aprils, possibly due to pension fund activities.
Broad Applicability: The profitability of relative strength strategies was not confined to any particular subsample of stocks. They worked across small, medium, and large firms, and across different beta groups, although returns were somewhat lower for the largest firms.
Historical Performance: Back-testing revealed that the strategy performed similarly in the 1941-1964 period. However, in the highly volatile 1927-1940 period, it actually generated significant negative cumulative returns due to extreme market mean reversion and the high betas of "loser" stocks.
The Role of Earnings Announcements
To further probe the "delayed reaction to firm-specific information" hypothesis, the authors analyzed stock returns around quarterly earnings announcements:
In the first 7 months after portfolio formation, past winners realized significantly higher returns around their earnings announcements compared to past losers. This aligns with the idea that the market was still incorporating positive news for winners.
Intriguingly, in the following 13 months (months 8-20), past losers actually realized higher returns than past winners around their earnings announcements. This pattern reinforced the observation that the initial outperformance eventually dissipates, suggesting a more complex underlying dynamic of market expectations.
Conclusion: A Challenge to Efficiency and a Call for Deeper Understanding
The work of Jegadeesh and Titman provided compelling evidence that buying past winners and selling past losers generated significant abnormal returns, which could not be explained by systematic risk or delayed reactions to common factors. Instead, the evidence pointed towards delayed price reactions to firm-specific information.
The observation that initial profits persist but then partially dissipate suggests that the simplistic notions of "overreaction" or "underreaction" might be insufficient to fully explain market behavior. The authors propose that perhaps investor transactions based on "positive feedback" (buying what's gone up) temporarily push prices away from their long-run values, causing an eventual correction. Alternatively, the market might underreact to short-term firm prospects but overreact to information about longer-term prospects.
This seminal paper, therefore, not only offered a powerful, actionable trading strategy but also issued a profound challenge to the concept of stock market efficiency, urging further research into the complex and often irrational patterns of investor behavior. It underscores that while the market may seem random, there are underlying, identifiable regularities waiting to be uncovered.