IT SHOULD not be possible to make money from simply buying past winners and selling past losers, but new research suggests it is, writes Proinsias O'Mahony.

'Cut your losses and let your winners run" - it's an old trading truism. Now, new research shows that there's more than a little wisdom to this old chestnut.

Investing in stocks with momentum - "the big mo", to use George Bush snr's oft-quoted phrase - helps to produce "consistent profits" that are "large and pervasive across time and markets".

That's the main finding from "the largest momentum study ever undertaken". The researchers - professors Elroy Dimson, Paul Marsh and Mike Staunton of the London Business School - have just published their findings in the annual ABN Amro Global Investment Returns Yearbook.

Using data dating back to 1900, the academics examined the results of a simple momentum strategy - buying the stocks that had been high-fliers over the past 12 months. They also constructed a portfolio that contained the market laggards over the same period. The stocks in each grouping would be held for a month and then sold, with the portfolio being re-calculated on a monthly basis.

They found that British winners (stocks that had been in the top 20 per cent of performers) continued to trounce losers (stocks that had been in the bottom 20 per cent), with a differential of more than 10 per cent.

A £1 sterling invested in the winner-portfolio in 1900 would have grown to more than £4.5 million by 2008 - an annual return of 15.2 per cent. In stark contrast, £1 invested in the loser-portfolio would have grown to just £111, or a paltry annual return of just 4.5 per cent.

While the "buy winners sell losers" strategy worked best among small capitalisation stocks, it was not confined to them. When investment was limited to the top 100 British stocks, an annual gap of 7 per cent was recorded.

If anything, the momentum effect appears to be increasing over time. Between 1955 and 2007, for instance, "hot" stocks went on to record annualised returns in excess of 18 per cent whereas beaten-up companies produced returns of just 6.8 per cent. The overall market saw annual returns of 13.5 per cent during that time.

Momentum investing is not just a British phenomenon. Using data covering a 33-year period, the authors looked at 16 other countries and found that the same strategy produced similar results in all cases.

Indeed, the Irish market was particularly prone to the momentum effect, with winners outperforming losers by 1.25 per cent a month. The professors also noted the winner/loser differential was "even higher" between 2001 and 2007, with 2007 in particular proving to be a bumper year for momentum investors everywhere.

The authors admit that the results are a "major puzzle" and fly in the face of the widely held theory of market efficiency. Most theorists posit that investors react quickly to new information, thereby bringing market prices into line with new realities.

"In well-functioning markets, it should not be possible to make money from simply buying past winners and selling past losers," the study says.

Indeed, in a recent Financial Times interview, Prof Marsh said that "most academics are vaguely embarrassed" about the findings.

Still, while the returns on offer look extremely attractive, the professors caution that "important caveats" exist.

Firstly, Prof Marsh said: "There are numerous periods when winners underperform losers, sometimes by a dramatic margin. Pure momentum plays are not for the faint-hearted."

Anyone who jumped into tech stocks at the height of the dotcom bubble will understand that when markets turn, they can do so mercilessly.

Secondly, transactions costs are likely to be substantial. Momentum tends to be a short-term effect - in the long run, markets tend to be mean-reverting, with winning stocks giving up their outperformance over time.

To profit from the momentum effect, investors need to rebalance their portfolios on a monthly basis, leading to sizable commissions in the process.

Of course, while Irish investors have to put up with stamp duty and pretty hefty broker charges, they can gain low-cost access to US markets. In 2007, for example, zecco.com took the concept of low commissions to a whole new level by offering clients up to 10 free trades a month. Zecco accepts Irish clients, as do many other US discount brokerages.

That brings us to the third caveat, however. Between 2001 and 2007, the momentum strategy stopped working for US markets. Considering that the same period saw a strengthening of the momentum effect in each of the 16 other markets analysed by the LBS team, the American divergence is striking. What's going on?

The obvious guess is that US markets are, quite simply, the most efficient in the world. Whatever the reason, the US dichotomy means that investors seeking to systematically exploit the momentum effect will have to consider more expensive markets.

Still, questions regarding ease of implementation aside, one thing is clear: momentum matters. "Most investors have styles that favour, or conflict [ with], with momentum," say the researchers, who point out that many hedge funds and growth investors are likely to be "followers" of momentum.

"Practices like letting winners run or cutting losses also implicitly play to momentum. However, value investors, small-cap funds and contrarians tend to suffer from momentum.

"Whatever their style," the professors continue, "momentum is highly relevant to all investors. Even if they do not set out to exploit it, momentum is likely to be an important determinant of their investment performance."