Two years of growth or decline: How to choose an investment strategy

Economists from HSE University, together with colleagues from international universities, have analysed stock market movements over almost a century and proposed an investment strategy that could have delivered returns nearly twice as high as the market average. Their research suggests following a momentum strategy during periods of sustained market growth and switching to a value strategy after prolonged market declines. The study has been published in the Journal of Banking and Finance.

wo main investment strategies dominate equity markets. The momentum strategy involves buying stocks that have recently performed well and selling those that have underperformed. The value strategy takes the opposite approach, purchasing relatively undervalued stocks while selling more expensive ones. Momentum tends to perform well during rising markets, whereas value investing generates stronger returns when investors shift their attention towards cheaper stocks. Investors may choose either strategy or combine the two in different proportions.

Following the global financial crisis of 2008, many investors concluded that value investing had lost its effectiveness. Undervalued stocks no longer consistently outperformed expensive ones, and the strategy popularised by Warren Buffett—which helped him build a fortune estimated at around $150 billion—appeared to have fallen out of favour.

However, Victoria Dobrynskaya, Assistant Professor at the HSE Faculty of Economic Sciences, together with her international co-authors, demonstrates that the value strategy remains highly profitable. According to the researchers, it performs well only under specific market conditions that have been largely absent in recent years.

The authors interpret their findings through the lens of behavioural finance. During prolonged market rallies, investor optimism can lead to the overvaluation of some companies and the undervaluation of others. When markets decline, optimism fades, allowing prices to return more quickly to levels that reflect companies' fundamental value. The researchers describe this sharp correction as a ‘value boom.’

The study examined the price movements of all stocks listed on the New York Stock Exchange and NASDAQ between 1926 and 2022. This period includes the Great Depression, the 1973 oil crisis, the dot-com crash and the 2008 global financial crisis. The researchers then repeated the analysis using stock market data from 20 developed economies.

Previous research assumed that returns from value investing were distributed relatively evenly over long investment horizons and that temporary losses would eventually be offset by future gains. However, the new study shows that almost all profits from the value strategy are generated during relatively rare value booms. The researchers identified 38 such episodes over nearly 100 years of observations. One striking example occurred in August 1932, as markets emerged from the Great Depression: the value strategy returned 68% in a single month after the market had lost around two-thirds of its value over the preceding two years.

Similar value booms were observed across the other 20 developed markets included in the study. Although the average annual return of the value strategy in these countries was 3.6%, it increased to 8.6% following significant declines in local stock markets.

Based on these findings, the researchers propose a new investment approach: investors should follow a momentum strategy when the market has risen over the previous two years and switch to a value strategy after a two-year market decline. Historically, this switching strategy would have generated annual returns of 18.5%, compared with 13.7% for a pure momentum strategy, 5.0% for a pure value strategy, and 9.6% for conventional blended strategies.

‘This switching strategy could also work in the Russian stock market. However, the Russian market moves more rapidly, so the optimal time horizon for switching may differ from two years. In addition, there are relatively few listed companies in Russia from which an appropriate portfolio can be constructed, which could reduce potential returns. This is an issue that requires separate research,’ said Victoria Dobrynskaya, Assistant Professor at the HSE Faculty of Economic Sciences.