Momentum investing is a stock investment strategy applied by some investors to take advantage of existing market trends to make higher than normal profits. As an investment strategy, momentum investing involves buying stocks that have shown consistent price increases on the short run such as over the last three months to one year and then selling them off immediately they show any sign of decrease.
Apart from buying ‘hot’ stocks and selling them off as soon as they show signs of weakness, momentum investors also sell ‘cold’ stocks. By applying momentum investing strategies, investors stand the chance of making mind boggling profits within a short time.
In analytic terms, momentum investing seems more of an involuntary reaction to spontaneous changes in market prices than a sound investment strategy. This is because momentum investing seems to contradict conventional investment wisdom which advocates buying low and selling high.
Economic analysts have found it somewhat difficult to establish a sound theoretical basis for the phenomenon called momentum investing and decades of research has not produced much in that regard until very recently.
Momentum investing can be compared to riding the crest of a wave and then getting off moments before the wave comes crashing down and then jumping on to the crest of another wave. Even though a sound theoretical basis is yet to be established to explain this phenomenon, it has undeniably been a vehicle by which some investors have made fortunes in a relatively short time. The efficacy of this method stands in sharp contrast when compared to the considerably lower profits made through conventional investment strategies.
Economists have found it hard to reconcile the sometimes staggering profits made through momentum investing by some investors with the efficient-market hypothesis. Conventional investment wisdoms stipulated by the efficient-market model is that it is not possible to beat the market because the efficiency of the market for stocks ensures that stock prices are a reflection of all possible underlying factors. In other words, expert stock analysis will not confer any investment advantages and the only possible way to make abnormal gain is by purchasing high-risk stocks.
However, momentum investors take advantage of the inherent volatility of markets caused by the tendency of men to react psychologically to either changes or signs of changes or news about the market to head off in a predictable direction. These reactions are usually spontaneous and popular thereby leading to exhibition of a behaviour described as the ‘herd’ instinct.
Momentum investors try to place themselves in the strategic position of the leader of the ‘herd’ and get out before others can react when the high wave is coming down.
How Does Momentum Investing Work?
Momentum investors take advantage of imperfections in the stock/securities market such as herd instinct of stockholders, over reaction and under reaction of investors and biased judgements of investors and stock owners.
Momentum investors purchase stocks that have had consistent price increases over the last quarter to a year and sell off those that have had consistent decreases over the same time span. It is a high risk strategy which aims at transferring assets as quickly as possible in response to changes in price performance of stocks so as to ensure a steady profit and high return on investment.
As an investment strategy, momentum investing requires expert knowledge of the stock market as well as constant monitoring of stock market performance indicators. To do this requires a lot of discipline and time which many investors may not be able to afford and hence this strategy may not be suitable for all investors.
Some of the successes achieved through momentum investing is attributable to seasonal effects such as tax evaluation induced buying and selling which affects the market prices of stocks in a way that distorts the rational basis of normal investment stock trading.
For instance, investors have a tendency of selling poorly performing stocks to avoid end of year taxation and when many stockholders sell at the same time the tendency is for stock prices to fall. As soon as the tax period is over, stock prices tend to climb up again. Momentum investors are deemed to make high profits as a form of compensation for the high risks they take.
Though the practice of momentum investing has existed before his time, Richard Driehaus is usually considered the father of momentum investing. This is due to the fact that he used this concept extensively in managing his funds and was very successful at it. Many techniques he applied have become the basics of this form of investing.
Potential Benefits of Momentum Investing
Momentum investing has a major potential benefit in terms of the speed with which an investor could accumulate wealth by making profits from several low time-scale equity/stock transactions. For instance, a momentum investor could buy a stock for a certain amount and sell it off at a profit of more than 50% at the slightest sign of a downward trend.
Bearing in mind that these transactions are not the usual annual, season-end transactions but transactions that have time scales of a week or a month, it is quite staggering the amount of wealth momentum investors could gather within a short time.
Potential Dangers of Momentum Investing
As much as momentum investing could potentially generate wealth for an investor, there are several pitfalls associated with it.
Firstly, momentum investing is time sensitive and wrong timing could mean loss of funds. Secondly, momentum investing requires constant monitoring of the market situation and as such is time consuming. Not everyone has the required discipline to maintain this constant focus and even for those who do, expert knowledge of the market is still a must.
Another drawback of momentum investing is the fact that it involves a high rate of turnover. This necessarily increases the total amount of money paid out as transaction fees.
Again, momentum investing is more effective in a bull market than in a bear market. The difference between a bull market and a bear market could be seen in their opposite market trends and investor behaviour. A bull market is characterized by upward market mobility and increasing greed of investors over a period of time whereas a bear market is marked by downward market mobility and fear among investors.
Essentially, momentum investors take advantage of general greed in the market to buy when prices are on the upward and sell before every other person reacts; thereby making huge profits from the irrational behaviour of the majority of investors.