Where mean reversion bets a stretched price snaps back, momentum bets the opposite: that a trend already in motion tends to keep going. Factor models formalize this and other persistent drivers of returns into rules-based portfolios.
Momentum is the observed tendency for assets that have recently performed well to keep outperforming over the following months, and for recent laggards to keep lagging — the mirror image of the mean-reversion idea from the previous lesson. It's one of the most extensively studied and persistent patterns in academic finance, showing up across stocks, sectors, currencies and commodities, though it isn't guaranteed to continue and can suffer sharp, sudden reversals ("momentum crashes").
A factor is a specific, measurable characteristic that has historically been associated with different returns across a group of securities. Momentum is one factor; others widely studied include value (cheap stocks relative to fundamentals outperforming expensive ones), quality (financially healthy companies outperforming weaker ones), and size (smaller companies historically carrying a different risk/return profile than larger ones).
A factor model builds a portfolio systematically around one or more of these characteristics — ranking a universe of stocks by a factor score and holding the top slice — rather than relying on any single stock-specific thesis. The appeal is diversification across many small, uncorrelated bets on the same measurable driver, instead of concentrated bets on individual company stories.
A simple momentum factor ranks stocks by their trailing 6-month return and holds the top decile. Five illustrative stocks from a hypothetical universe:
| Stock | 6-Month Return | Momentum Rank | Illustrative Action |
|---|---|---|---|
| Stock A | +42% | 1 | Hold (Top Momentum) |
| Stock B | +31% | 2 | Hold (Top Momentum) |
| Stock C | +8% | 3 | No Position |
| Stock D | -6% | 4 | No Position |
| Stock E | -19% | 5 | No Position (Bottom Momentum) |
A momentum factor strategy holds Stocks A and B not because of any specific view on their businesses, but purely because their trailing return ranks them at the top of the universe — the same rule applied systematically across hundreds or thousands of names.
Enter trailing returns for up to 6 assets — see them ranked by momentum, with the top slice highlighted as an illustrative "hold" group.
| Asset | 6M Return | Rank | Action |
|---|
Model: assets are sorted by trailing return, highest first, and the top N are marked "Hold" — a simplified illustration of how a momentum factor ranks a universe, not a real trading signal.
Answer all five, then hit "Check My Answers" to see how you did. Get one wrong? No problem — the explanation will show you exactly why.
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You've now seen two opposing rules-based edges — mean reversion and momentum. The next lesson covers how to properly test either one against history before risking real money.