The rationale for momentum trading - It is underreaction

Momentum, as a significant and measurable risk factor, still perplexes many researchers. Why does it exist? The argument is that it is behavioral bias does not exactly illuminate. Of course, there is something about investor behavior that creates an overreaction or slowness in price reaction which creates momentum.

There are several competing theories: overconfidence, slow diffusion of information, limited attention, anchoring bias, and real options. More recent evidence focuses on a frog-in-the-pan (FIP) hypothesis which suggests that due to limited attention, investors under-react to information that slowly adjusts. Trends in information lead to trends in prices because of limited attention. 

A new paper "What Explains Momentum? A Perspective From International Data" looks at all these alternatives and concludes that the frog-in-the-pan (FIP) hypothesis effectively fits the data through testing across international stocks out-of-sample. This is a complex paper because it tests a wide set of hypotheses, but it provides insight on all the thinking on momentum. 

Market underreact to slow adjustments in information. Investors have a lack of attention on small changes in underlying information. This same thinking can be applied to trend-following.