Sometimes it seems there are as many different investment strategies as there are investors. Momentum investing is a popular strategy that relies on a simple yet surprisingly effective principle: Follow the trend.
But what does this mean in practice, and why has momentum investing remained a viable approach? Let's explore the appeal of momentum investing, the basics and how it works in real-world scenarios.
What is momentum investing?
Momentum investing is a strategy that involves buying assets that have recently performed well, and selling those that have underperformed.
The idea is based on the concept that assets that have demonstrated strong past performance should be likely to continue their upward trend (or downward trend, in the case of short selling). This approach leans into the psychological behavior of market participants, where investor sentiment and herd mentality can cause trends to persist for some time.
All investment involves risk. At its core, momentum investing capitalizes on the theory that markets have a tendency to move in waves. It theorizes that when stocks, sectors, or broader markets gain momentum, they often should outperform because more investors would jump on the bandwagon, fueling further gains. However, momentum investing can also involve shorting stocks or exiting positions when the market is on a downward slope.
Momentum investing basics
There are a few foundational principles that guide this strategy:
The trend is your friend
Momentum investors identify stocks with recent strong performance and ride the wave. Instead of trying to predict when a stock will peak or hit bottom, they focus on identifying trends and taking full advantage until the trends naturally reverse.
Past performance as an indicator
Momentum investing relies on the idea that past performance should, to some extent, indicate short-term future performance. (Bear in mind, of course, the ubiquitous disclaimer: Past performance does not guarantee any future results).
By looking at an asset’s recent returns over a specific period (for example: three, six, or twelve months) investors seek to identify those stocks with the highest likelihood of continuing to perform well.
Market inefficiencies
Momentum investing attempts to exploit inefficiencies in the market caused by biases like investor overconfidence, overreaction, or underreaction to news. These psychological tendencies often can create price trends that savvy momentum investors can leverage.
Why momentum investing appeals
Momentum investing has grown in popularity for various reasons:
- Simplicity: Unlike strategies that require deep knowledge of financial analysis or complex valuation models, momentum investing is relatively straightforward. The focus is on identifying trends rather than dissecting a company’s balance sheet.
- Historical outperformance: Numerous studies and real-world data suggest that momentum strategies, under certain conditions, have outperformed traditional buy-and-hold approaches and other investment methodologies. The S&P 500 Momentum Index has appreciated by 131.55%1 over the past five years, compared to 87.55%2 for the S&P 500.
- Compatibility with technology: Advances in trading technology and data analysis have made it easier than ever to identify momentum trends, making it possible for individual investors to pursue this strategy effectively.
- Flexibility: Momentum investing is possible across a variety of asset classes, including stocks, commodities, and cryptocurrencies, making it versatile and accessible.
How momentum investing works in practice
To illustrate, imagine you’re tracking two stocks, Stock A and Stock B. Over the past six months, Stock A has consistently increased in value by 15%, while Stock B has remained flat. A momentum investor would likely choose to invest in Stock A, assuming its upward trend is likely to continue, at least in the short term.
Momentum investors might use a tool such as a moving average to confirm a trend. A moving average is an indicator that smooths daily price movements to establish a trend in price by creating a constantly updated average price.3
When the momentum reverses and the performance starts to falter, the investor would exit their position and potentially switch to another asset showing stronger growth.
Momentum vs. other strategies
Momentum investing often stands in stark contrast to approaches such as value investing. While value investors focus on finding undervalued assets based on intrinsic fundamentals, momentum investors tend to prioritize price trends and ignore whether a stock looks "cheap" or "expensive." This difference in philosophy can lead to very different portfolios.
Interestingly, momentum and value strategies can occasionally complement one another. Some investors use momentum to leverage short-term trends while sticking with value stocks for long-term growth. This hybrid approach balances the strengths of each.
Pitfalls in momentum investing
Despite its appeal, momentum investing isn’t without risks. Critics often point to its reliance on short-term price movements, which can be vulnerable to sudden reversals. For instance, a stock that has been trending upward could decline sharply after unexpected news or a market correction, resulting in significant losses for a momentum investor.
Moreover, the strategy can sometimes lead to more frequent trading, which can entail higher fees and taxes for individual investors. Such costs can erode gains, particularly in markets with thin margins.
Finally, momentum investing works best when markets are directional and trending. During periods of volatility or conditions of mean reversion, the strategy may struggle to deliver consistent results.
The takeaway
Momentum investing is a powerful strategy that has earned its place among the most popular investment approaches. Its simplicity, adaptability, and historical performance make it an attractive option for investors looking to capitalize on market trends.
However, as with any strategy, it’s not without its challenges. Investors should maintain a disciplined approach to avoid getting caught out by sudden market reversals.
New investors might consider experimenting with momentum strategies in small, manageable ways. Start by tracking a few high-performing stocks or ETFs, evaluate their historical trends, and make informed decisions based on the principles we’ve discussed above. With time and practice, momentum investing can become a valuable part of your overall investment strategy.
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