There are a number of variations on the theme, but the basic idea is that stocks are ranked from the highest to lowest according to their return over a prior period. The top-ranked performers are bought and held for a period of time, and then the process is repeated after a fixed holding period. A typical long-only momentum strategy might involve buying the top 25 performing stocks in the S&P 500 over the past year, holding them for a year, selling them, and then repeating the process.

This may sound like an absurdly simple strategy, and it is, but it has consistently returned results that defy expectation. But why? As you can imagine, a lot of research has examined this effect, and the hypothesis is that there is something inherently systemically biased about how humans deal with new information. The research suggests they underreact to news in the short term and then overreact to news in the long term. This means that, when stocks begin to rise on exceptionally good news, investors don't fully elevate the share price to the level that would fully reflect this news; it takes time for them to come around to incorporating this rosy outlook.

So, will momentum strategies be arbitraged away as more traders learn of it and pile in? There has been some evidence of this in recent years, but it remains unclear. Regardless, the effect was demonstrably real and persisted far longer than can currently be accounted for by the efficient market hypothesis. So, there at least appears to be some hope for market prediction. With that in mind, let's now move on to exploring how we might go about unearthing our own market anomalies.