blog on backtesting investment strategy

Exploring the Momentum Hypothesis with Elon and Lemonade

People love throwing a controversial strategy into investing. It’s nice when it could be financially beneficial. One such trading strategy that is continually debated is the Momentum Hypothesis. The hypothesis asserts that companies that go up in price over a period of time are more likely to continue going up in price. 

Simply put, the good only gets better.

Why does this hypothesis matter? Because it supports the belief that if you’ve invested in a stock that has done well in the past, it will continue to do well in the future. It focuses on a price’s ability to sustain itself and continue profitability, emphasizing a behavioral finance approach.

A Lemonade Stand’s Momentum

If you remember Rebecca from previous examples, she has quite the lemonade stand! 

Rebeca worries that her customers won’t want to buy lemonade despite the recent heat they have experienced across the United States. She sets up her lemonade stand on Monday morning anyway. The weather is hot, over 100 degrees, and there is an increased demand for her lemonade. For that particular Monday, she increased her revenue and profits because of the number of customers she served. 

There could be multiple reasons she was successful; weather, location, quality of lemonade, or word of mouth. But the momentum hypothesis suggests something different!

The momentum hypothesis would argue that she had success in the past, so she had success again, and then she will continue to have success in the future. This is because of the momentum that is creating a continual profit. 

An investor might look at Rebecca’s lemonade stand and think, “If I invest while this lemonade is experiencing momentum, my profits will increase. If there’s a decline, I can sell my shares.” 

Real-Life Momentum

It may be a hypothesis, but there are applicable examples of the momentum strategy. A controversial company that has been affiliated with this strategy is Tesla. Elon Musk’s finance bros got behind TSLA, but that can’t be the only reason it is successful. 

The below graph shows Tesla (in green) from 2013 to 2023, with ups and downs, but still a very successful business! 

Is it successful because of innovative technology, business strategy, and investor support? Maybe it all hacks up to momentum. The idea is that the good gets better. Tesla might make you squirm, but it has soaring prices that could be because of the very things asserted in the momentum hypothesis. 

Why do we care? 

Equities Lab cares about prevalent strategies that investors apply to the market, and we want you to know all about them. This might seem like a loosely based hypothesis, maybe not the one for you. Follow along with us to find out about different hypothesis that come up and see which ones work for you. You will see more trends that could sway you positively or negatively toward stocks that perform well.