Momentum Investing: Meaning, History, Types & Advantages

Have you ever seen an unexpected spike in the price of a stock? After seeing it, everyone seems to rush in like it’s a bar fight over the final slice of pie. That is an oversimplified idea of momentum investing. 

Momentum investing is the practice of purchasing stocks experiencing an upward price trend and selling those experiencing a downward price trend. Making money off of current market trends is the aim. Utilizing the current trends in the industry is a part of the procedure. This strategy is based on the idea that stocks that have performed well historically will continue to do so going forward.

What is Momentum Investing?

When you trade based on momentum, the idea is “buy high, sell higher”. It comes from the idea that assets that have done well in the past will continue to do well in the coming future. People often use this approach because they’ve seen that stocks that have done well in the last three to twelve months tend to keep doing well, and stocks that have been doing poorly tend to continue doing poorly.

History of Momentum Investing

The concept of momentum investing is not new. Its origins can be traced back to the 19th century. Richard Driehaus is known to have modernized the strategy, emphasizing the concept of “buy high, sell higher.” Momentum investing was empirically validated by academic studies, including those conducted by Jegadeesh and Titman in the 1990s, illustrating that stocks with robust recent performance are more likely to maintain their performance.        

Momentum Investing Key Concepts 

There are a few key concepts of momentum investing. They are explained in detail below:

A. Price Momentum

This investment strategy is founded on the principle of price momentum. It entails identifying assets with either upward or downward price trends over a specific period. Investors typically screen for securities with the most robust price performance in the past six to twelve months.

B. Strength in Relationship 

Another fundamental principle of momentum investing is relative strength. It entails comparing a security’s performance to a pertinent benchmark, such as a sector or index. Under this strategy, stocks with greater relative strength than their counterparts are considered appealing investments.

C. Following Trends

Momentum investors frequently follow market trends to capitalize on existing price fluctuations. This involves identifying and investing in assets that are trending in a specific direction, such as an uptrend in an optimistic market. 

Momentum Investing Strategies

There are many momentum strategies that are used by traders to generate above-average returns. Some of them are mentioned below. 

1. Relative Strength Strategy

It involves ordering securities based on their past performance record, most often for a specific duration such as three, six, or twelve months. Investors subsequently select the best-performing securities and sell off the worst.

2. 52-Week High/Low Strategy

A stock is bought when it is close to its highest level over the past 52 weeks. Otherwise, it is sold or shorted when it is near its lowest over the same period. This strategy believes that securities approaching new peaks are more likely to continue rising due to upbeat investors’ attitudes and sustained buying pressure.

3. Momentum Oscillators

Technical indicators such as the Relative Strength Index (RSI), Moving Average Convergence Divergence (MACD), and Rate of Change (ROC) are used to identify momentum of stocks. These indicators can signal overbought or oversold conditions and potential trend reversals, guiding buy or sell decisions for traders.

4. Earnings Momentum

This strategy focuses on shares of companies that have consistently exceeded earnings expectations. Investors buy stocks of companies that have recently reported positive earnings surprises and strong earnings growth, anticipating that the momentum will continue.

5. Sector Rotation

This involves moving investments from one sector to another based on the relative momentum of different sectors. Investors shift their portfolios into sectors showing high performance and away from those showing low performance.

6. Price and Volume Trends

Investors analyze price trends and trading volumes to confirm momentum. A high volume of upward price movement indicates strong buying interest and can signal to buy, while a high volume of downward price movement can signal to sell.

Advantages of Momentum Investing

• Opportunity to earn higher returns: Momentum buying can yield big gains, especially when the market is moving strongly. By riding the current wave of progress, buyers may be able to make money as prices continue to rise in certain assets.
  
• Spreading out: Momentum investing can help more if you spread your investments across different assets that have strong momentum. This may lower risk and increase the overall return-to-risk ratio.
  
• Rules and ease of use : Many buyers like momentum trading because it is easy to understand and is based on clear rules. It gives you a structured way to earn profit from current market trends.

Disadvantages of Momentum Investing

• Risk and Volatility: Due to the stock market’s extreme volatility, momentum investing can result in substantial losses during market trend reversals. The strategy may put investors at greater risk since it depends heavily on short-term price fluctuations, particularly during volatile times. 
  
• High Charges for Transactions: Frequent trading may impact the total profits of momentum investing due to increased transaction expenses. For smaller investors, the strategy’s profitability may be weakened by the accumulation of trading costs.

Conclusion 

By taking advantage of current market movements, momentum investing is a dynamic and fascinating technique that has attracted attention due to its potential to generate substantial profits. But it comes with its own set of difficulties. Success in investing based on momentum requires careful planning, risk management, and a long-term outlook, just like any other technique. Ultimately, an investor’s risk tolerance, financial objectives, and market forecast determine whether or not they choose to use momentum investing in their investing journey.

In summary, momentum investing is an effective strategy for navigating the financial markets. It allows investors to increase returns by giving them a framework for recognizing and taking advantage of current price trends. However, before incorporating momentum investing into your portfolio, you must thoroughly assess the risks involved and consider your unique investment goals.

Frequently Asked Questions (FAQs)