Explainer: What is Momentum Investing?

23 December 2019
Private investors may employ many different strategies in an effort to maximise returns. Three of the most fundamental of these include value, growth, and the topic of this particular post, momentum.

So, what exactly is the momentum investing strategy?

Momentum investing reverses the more traditional stock maxim of buying low and selling high. Instead, momentum investors adopt an approach of buying high with a belief stocks will sell even higher. 

Typically, momentum investors will look for stocks that have performed well over a longer period of time (three to twelve months on average) and only sell these stocks when they have been in a lengthy negative period.

These investors may use different methodologies to decide when to buy or sell stock, making momentum investing more of an ‘active investing’ endeavor. They may look for complex technical indicators that help them determine whether to buy a certain stock or asset.

Investors can use longer-term moving average to determine strong potential entry and exit points for certain stocks, or opt to go long with ETFs showing the strongest momentum while shorting those with weakest momentum. They may also employ cross-asset analysis by monitoring the yield curve of a similar share or index.

Related article: What is Growth Investing?

The Driehaus Strategy

A Chicago-based fund manager by the name of Richard Driehaus was one of the first to widely promote the strategy, and is still an avid proponent of it. In fact, employing the Driehaus Strategy is a way many investors may choose to select stocks.

Some key indicators in choosing stocks based on Driehaus’ Strategy are:

  • Choosing stocks that are indicated as a ‘Strong Buy’ on the Zacks rank
  • Shares that have had a 50-day moving average percentage that is positive and indicating an uptrend
  • Looking to invest in companies who have had Earnings Per Share growth rates of over 2% on average in the last five years
  • A high Momentum Score (which is determined by looking at a companies one-year total returns)

Possible Benefits of Momentum Investing

Momentum investors are able to take advantage of other market participants’ behavioral biases. With the correct screening and strategizing process in place, it may be possible to use momentum investing to generate excess returns adjusted to risk.

Momentum investing may also be particularly advantaged by seasonal trends, as it is by its nature a strategy that aims to follow market sentiment. In a good market, momentum investing may add to growth compared to more of a ‘buy and hold’ strategy.

Risks With Momentum Investing

On the other hand, while a strong market in conjunction with momentum investing may increase growth potential, momentum investing can fail to protect capital when the market is performing poorly.

Momentum investing also may involve investing in market leaders, so if there is a market transition and this leadership changes this can leave their investors struggling to keep up.

Source: Shutterstock

Is momentum investing for you?

At the end of the day, any investment approach or strategy can only be determined by an individual based on his or her personal circumstances. Those fairly new to investing, or not intending to devote sufficient time to trading, would be ill-advised to dive headfirst into the momentum investing strategy without further research. We’ve only given a brief overview of the momentum strategy today, and there are plenty of resources out there for those looking to know more. The Investor’s Podcast have an episode specifically dedicated to the strategy, while Seeking Alpha’s Podcast explores some of its downsides.

When in doubt, consult a professional finance adviser.

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