Albert Einstein introduced the concept of momentum in his first law of motion. Momentum is nothing but the force or energy exhibited by a moving body.
The moving body could be anything. It can be a car, stone, or even a financial asset (like stock, crypto, gold, etc.)
Yes, you heard it right. Even securities exhibit momentum, and one can profit from it. In fact, an entire investment strategy called ‘Momentum Investing’ is designed around this concept.
In this article, we will look into the nuances of momentum investing strategy and how one can utilize it to generate returns.
Let’s dig in.
What Is Momentum Investing?
If you were an investor, you would have frequently encountered this statement.
“Buy Low and Sell High.”
It is one of the well-known ideologies that aim to take advantage of price appreciation. The challenge is it’s easier said than done. Almost no one can predict the price to buy or sell the asset. In hindsight, it’s easier to spot the highest highs and lowest lows. But in real-time, it’s impossible.
Luckily, momentum investing brings a slightly different perspective here.
Advocates of the momentum investing strategy bet on the assumption that once a trend is set, it’s likely to continue.
For instance, if security moves in an upward trajectory, it would continue to move in that direction, at least in the short term, and reach even higher prices. The same is applicable if an asset is showing downward momentum. Investors can short-sell the asset as it is expected to go down even further in the near term.
Momentum investing encourages people to ride the wave with the belief that the trend will continue for a while. It would be easier than finding the precise price points to enter and exit the market.
Reason Behind Momentum Effect
There is no consensus among finance experts regarding the validity of the momentum investing strategy.
But there are two plausible explanations to support this concept.
1. Investor bias
The first reason is linked to investor bias which is explained through behavioral finance. Investors often tend to develop either positive or negative emotions towards assets, which can affect how they invest. Positive emotions about an asset can lead to overreactions where even a small piece of good news about the asset can increase the amount invested in it.
Likewise, negative emotions can result in under-reactions where even good news doesn’t create the correct response from the investors. Such reactions often lead to pricing inefficiencies.
2. Time to react
The second reason is associated with the timing — how long it takes for investors to react to a piece of news regarding the asset.
Sometimes, investors hesitate to react to new information and wait to see how it develops. Once they get confirmation, they do a hurried follow-up to catch up, which drives the momentum. Such a tendency is called ‘following the herd.’
How Does Momentum Investing Function
Momentum investing is a technical analysis tool.
Thus, it is heavily dependent on the technical parameters of the asset rather than the fundamental or operational performance. Momentum investors apply technical indicators to identify the following aspects before investing.
- Direction of the trend: It can be either upward or downward.
- Strength of the trend: It can help them understand if there is enough momentum for the existing trend to continue for some more time.
Momentum investing is typically a short-term strategy lasting 6 to 12 months. Its objective is to capture a portion of the price movement in an existing trend and realize profits from it.
The following steps can help better understand the entire process flow of using the momentum strategy.
- Step 1: An investor or trader uses technical indicators such as trend lines and moving averages (MA) to identify the presence of a trend. Sometimes, they use advanced momentum indicators such as the Average Directional Index (ADX).
- Step 2: As the trend gains momentum, a trade is initiated in the direction of the trend — buying an uptrend or selling a downtrend.
- Step 3: When the trend’s momentum shows signs of weakening, the trade is closed to realize the profit (or loss) made.
Momentum Investing Strategies
Below are the two types of strategies aimed at capturing the momentum of a trend.
1. Time-series or absolute momentum
In this strategy, the performance of an asset is compared to its historical returns.
For instance, let’s look at a stock’s returns for the last year on a quarterly basis. Suppose the stock consistently gives positive returns over the previous four quarters, and the returns are consecutively higher for each quarter. It means the respective stock is moving upward and will likely continue in the same direction.
2. Cross-sectional or relative momentum
In this strategy, a particular asset’s performance is compared to other investments in a portfolio.
Let’s say, over a year, crypto gave 12% returns, whereas the share market gave only 8%. It could mean that crypto is under a positive momentum, at least in the near term.
Momentum investing is all about riding the wave without thinking much about the fundamentals of the asset.
According to several studies, momentum investing is successful. But, investors need to be aware of the overall risks of implementing this strategy.
1. What is dual momentum investing?
Dual momentum investing uses both absolute and relative momentum strategies.
- As a first step, the asset that has outperformed others in the portfolio over a specified time frame is identified.
- As the next step, its current returns are compared with its historical returns. If it is giving positive returns, one can trade it.
The rationale behind this strategy is that an asset with a ‘greater relative momentum’ and a ‘positive absolute momentum’ would continue to perform better until another asset class beats it.
2. Is momentum trading risky?
Momentum trading comes with its own set of risks, and the major one is high volatility. Using this strategy, you invest in an asset based on only one factor — momentum.
If a stock has been giving positive returns in the last six months and is in an uptrend, an investment is made, hoping that the uptrend will continue for some more time. If the stock price does go up, the investor makes good returns. However, if the trend suddenly changes, there could be huge losses. Even if the stock price stays flat for a while, it leads to opportunity costs as the money could have been invested in return-generating assets.
3. Is momentum investing for the long term?
Momentum investing is suitable for the short term. Since it involves riding the existing momentum of an asset, it’s ideal for an investment period within 12 months.
But one can apply it for the long term as well. If there is an uptrend in a sector, it could continue for a few years. For example, steel and real estate are cyclical industries that have extended business cycles of 4 to 5 years, following a single trend (either upward or downward).