Reasons for the momentum effect point to investor behavior, persistent supply, and demand imbalances, a positive feedback loop between risk assets and the economy, or the market microstructure.

The behavioral reasons reflect biases of under-reaction and over-reaction to market news as investors process new information at different speeds. After an initial under-reaction to news, investors often extrapolate past behavior and create price momentum. The technology stocks rally during the late 90s market bubble was an extreme example. A fear and greed psychology also motivates investors to increase exposure to winning assets and continue selling losing assets.

Momentum can also have fundamental drivers such as a positive feedback loop between risk assets and the economy. Economic growth boosts equities, and the resulting wealth effect feeds back into the economy through higher spending, again fueling growth. Positive feedback between prices and the economy often extends momentum in equities and credit to longer horizons than for bonds, FX, and commodities, where negative feedback creates reversals, requiring a much shorter investment horizon. Another cause of momentum can be persistent demand-supply imbalances due to market frictions, for example, when commodity production takes significant amounts of time to adjust to demand trends. Oil production may lag increased demand from a booming economy for years, and persistent supply shortages can trigger and support upward price momentum.

Market microstructure effects can also create price momentum related to behavioral patterns that motivate investors to buy products and implement strategies that mimic their biases. For example, the trading wisdom to cut losses and let profits run has investors use trading strategies such as stop loss, constant proportion portfolio insurance (CPPI), dynamical delta hedging, or option-based strategies such as protective puts. These strategies create momentum because they imply an advance commitment to sell when an asset underperforms and buy when it outperforms. Similarly, risk parity strategies (see the next chapter) tend to buy low-volatility assets that often exhibit positive performance and sell high-volatility assets that often had negative performance. The automatic rebalancing of portfolios using these strategies tends to reinforce price momentum.