What is momentum investing?
Momentum investing reverses the traditional investor approach of buying low and selling high. Instead, momentum investors adopt an approach of buying high with a belief that the stocks will sell even higher.
Typically, momentum investors will look for stocks that have performed well over a longer period of time (for example, 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 a stock, making momentum investing suited to active investors. They may look for complex technical indicators that help them determine whether to buy a certain stock or asset and have certain benchmarks and metrics set for when it is the right time to sell. Investors can use longer-term moving average to determine strong potential entry and exit points for certain stocks.
Momentum investing looks to take advantage of market volatility and trading in momentum markets requires high-risk tolerance, and sophisticated rules to mitigate the impact that volatility and overcrowding can have on share price.
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. His philosophy was to “buy high and sell higher”, believing in selling stocks that are losing and letting the winners grow higher. He would then invest the money from the losing stocks he sold into new stocks that were starting to grow in price.
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 company’s one-year total returns)
Related article: 5 of the Most Common Financial Ratios
Possible Benefits of Momentum Investing
Momentum investors are able to take advantage of other market participants’ behavioural 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 a strategy that aims to follow market sentiment. In a good market, momentum investing may add to a higher level of growth compared to a ‘buy and hold’ strategy.
Risks With Momentum Investing
While implementing momentum investing as a strategy in a strong market may increase growth potential, momentum investing can fail to protect capital when the market is performing poorly. There are a significant amount of risks that need to be managed when momentum investing, otherwise, it is very likely the strategy will fail. Furthermore, as there is a high turnover of stock using this strategy, brokerage fees can become expensive. It can also be greatly time intensive as investors have to monitor the markets daily (if not hourly!) to ensure they sell in early and get out fast. This includes being across all related news that could impact the stock’s market sentiment.
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. This is a brief overview of the momentum strategy, and there are plenty of resources out there for those looking to know more. The Investor’s Podcast has an episode specifically dedicated to the strategy, while Seeking Alpha’s Podcast explores some of its downsides. When in doubt, consult a professional financial adviser.
Compare Online Share Trading Accounts with Canstar
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