Understanding Momentum Investing: A Time-tested Investment Strategy

Introduction

Contrary to the traditional wisdom of buying low and selling high, there is an old and well-known principle of ‘buy high and sell higher’ or ‘sell low and buy lower.’ With Momentum Investing, investors cash in on a trend they see strengthening, which could be upwards or downwards. Investors act after identifying a specific price trend that will likely stay the same even shortly.

What is Momentum Investing?

Momentum investing is a strategy where investors pick assets based on their performance in the recent past and expect the trend to continue. They may buy or sell the investment depending on the trend’s strength. This strategy is used for asset classes such as stocks, bonds, commodities, derivatives, and indices.

Most importantly, Momentum Investing is a technical strategy where investors use technical indicators to identify and assess the trend’s strength when analyzing an asset.

Being successful with Momentum Investing requires a thorough understanding of the market and its workings, following a disciplined approach, and possessing the agility to respond to changing market dynamics.

What Causes Momentum Investing?

Some reasons to explain what causes the Momentum effect are:

• The first reason emerges from behavioral finance and the resulting investor bias. By overreacting or underreacting to information, they cause price changes that lead to price inefficiencies.

• Also, market timing is another crucial factor when investors, having realized the importance of new information, act hurriedly after reacting slowly.

• The other possible reason could be the investors’ natural tendency to follow others, lest they miss lucrative opportunities.

• Investors buy a stock when it is rising and thus further drive up its price. It is self-rewarding and causes the price to rise.

• Then, there are other factors, such as market trends, economic conditions,  and the use of tools to identify securities with a strong momentum.

Tools for Momentum Investing

Investors seeking to capitalize on the trends in asset prices employ one of the following tools:

• Moving Averages (MA): This method of identifying trends helps investors identify trends in stock price. They buy when the stock price crosses the MA and is consistently above it. Meanwhile, investors sell when the stock price stays or falls below the MA.

• Trend Lines: A trend line indicates a bullish or bearish market when drawn between two successive points on a price chart. If the line slopes upward, it indicates a bullish sentiment, and investors may buy shares. If it slopes downward, the trend is negative or bullish. The investors can then sell them. 

• Relative Strength: Investors use this strategy to compare a security’s performance to a benchmark or its peers. They then invest in a stock that has strong relative strength.

• Stochastic Oscillator: With this tool, investors compare an asset’s nearest closing price to a range of prices over a period. It signals a positive or negative trend, depending on whether the closing price is near the high or low of the price range. 

• Average Directional Index (ADX): The ADX is a reliable tool used to determine the existence of the trend and its strength. The index calculates a security’s price range expansion/contraction during a specified period.

Some other popular tools to indicate momentum are Relative Strength Indicators, Price Rate of Change, and Moving Average Convergence Divergence. 

 Types of Momentum Investing Strategies 

• Time-series or Absolute Momentum: When using this strategy, investors compare an asset’s performance to its historical performance to help identify shares that have rallied the most.

• Cross-sectional Momentum: Also called relative momentum, investors compare the asset’s performance with comparable assets. 

Pros of Momentum Investing 

• Investors buy an increasing asset and can realize profits when they sell.

• By investing amid volatility, investors can maximize the return on their investment.

• Momentum investing offers the opportunity to make high profits in less time.

• Even though recent, investors can take advantage of the prevailing trend by following an established trend.

• By using this method, investors also gain as they may profit from the other market participant’s behavioral biases. 

Cons of Momentum Investing 

• Momentum investing follows from investors’ relatively recent buying behavior, with no certainty that this trend will continue.

• There is a risk of loss if investors fail to sell stocks.

• The other mistake is selling a stock too soon when its price rises.

• The scope for momentum in an investor’s portfolio should be high as momentum reacts more to turnover than other factors.

• There can be trading costs associated with momentum investing, as low-momentum stocks should be replaced with high-momentum stocks when momentum breaks down.

• Momentum investing is not a great indicator when the market undergoes a significant change, as it takes time for momentum to pick up that event.

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Conclusion 

Momentum Investing is an accepted investment strategy in the investor community that works on behavioral finance. Even though there are some benefits, there are inherent risks. Nevertheless, Momentum Investing continues to be actively used as investors have made gains.