Momentum investing: A advanced investing strategy that focuses on going long on upward-trending securities

view original post
  • Momentum investing is an investment strategy that rides the inertia of recent stock price movements. 
  • Research on momentum investing shows that the last three to 12 months of a stock’s activity is a good indicator of the next three to 12 months of activity.
  • Momentum investing works best when the market is showing a clear direction, either up or down.

In physics, an object in motion will stay in motion until it’s acted upon by an external force. Momentum investors apply the same rule to stock prices, expecting a growth trend to continue over the course of a few months.

Momentum investing takes on an overall different approach to the stock market compared to other investing strategies, focusing on the pure market instead of fundamentals that drive the market. Yet, you might encounter bits and pieces of other strategies folded into this relatively complex short-term investment strategy.

What is momentum investing?

When we say that momentum investing is generally unconcerned with fundamentals, we mean that momentum investors generally ignore factors like the structure of the business or the quality of the product being offered. Instead, momentum investors focus on the market and the rate of change in a stock’s price over an intermediate period of time, a few months up to a year.

Put very simply, momentum investing works on the belief that if a stock’s price is increasing, it will continue to increase in the intermediate term. Once that momentum dries up — either the price has plateaued or starts declining —  it’s time to sell. 

How momentum investing works

Compared to other investment strategies, momentum investing is relatively complicated to understand. Richard Driehaus, the late founder of Driehaus Capital Management LLC, is often considered the “father of momentum investing.” His modus operandi was often boiled down to “buy high, sell higher.”

While Driehaus popularized the strategy, the research that supports momentum investing was published by Narasimhan Jegadeesh and Sheridan Titman in 1993. They found that from the years 1965 to 1989, the investment strategy that would later be known as momentum investing — selling recent winners and shorting recent losers — outperformed the overall market. Specifically, the returns within the last three to 12 months were a good indicator of how the stocks would perform during that timeframe. 

Stock selection

Robert Nestor, the chief executive officer of Qraft Technologies USA, says that momentum investors consider five academic factors when picking stocks: profitability, momentum, value, volatility, and size. 

Profitability: The best indicator of a stock’s profitability, also called quality, is the cash flow moving through a company. 

Momentum: A stock’s momentum can be measured by its percent change over a defined time period, essentially its rate of change. 

Value: This takes a page out of value investing’s book. Momentum strategies gravitate toward companies that are undervalued. This means that a company has a low price-to-book ratio, and the price of the stock is low compared to the earnings that the company is making. 

Volatility: In momentum investing, volatility is measured in relation to the overall market, quantified by beta. If the beta is 1, that means that a stock’s volatility is equal to the market. A beta under 1 indicates lower volatility relative to the market and vice versa for a beta over 1. Investing in stocks with a beta under 1 will lower the risk you take on as a momentum investor.

Size: Titman and Jegadeesh’s research indicates that stocks from small and medium-sized companies tend to outperform larger firms in momentum strategies. Small-cap stocks are from companies valued at under $2 billion while mid-cap stocks are valued between $2 to 10 billion. Choosing these relatively small companies isn’t uniquely a momentum strategy. Growth investing also focuses on these smaller companies in the hopes that they’ll grow faster and outperform the market. But this strategy looks at these small-cap stocks in a more qualitative, fundamental way. 

The most promising stocks for momentum investing often align with broader industry trends. “For the last five years, most momentum strategies have been overwhelmingly allocated to tech,” Nestor says. However, strategies have since shifted over to energy as tech stocks lost momentum beginning in late 2021. 

Entry and exit points

Institutional momentum investors approach entry and exit points formulaically. “If you start with an index methodology, most index approaches have some periodic, stated rebalancing period,” Nestor says. At that point, they take another look at their position’s history and rebalance. “It sounds incredibly simple, and in a lot of ways, it is.” 

There isn’t necessarily a moment where you need to jump into a stock with this method, as long as the momentum is still there. However, as a retail investor, you might not have that kind of structure. At that point, a good time to invest is the moments after an earnings surprise, when a company’s earnings report exceeds expectations. 

The market tends to overreact to news, so news like this is likely to provide returns that will exceed the actual excess earnings reported, which momentum investors can take advantage of. On the other hand, once that price momentum stops, it’s time to take that money and put it into the next stock. 

Is momentum investing a viable strategy?

If you’re new to investing, you might want to rely on other strategies for the bulk of your investing. Not only is it complicated, but it is also an active investing strategy. You need to react quickly to price movements, which can be difficult with the rest of your life going on at the same time.

Though momentum investing might not be connected to fundamentals the way that a strategy like growth investing is, the viability of momentum investing correlates with overall market trends in similar ways. In times of growth momentum investing does very well. On the other hand, Nestor says that when the choppy markets are bad for momentum investors. “The lack of price trends, particularly at the sector level, will tend to be bad for momentum investing,” he says. 

Nestor says that a particularly bad trend for momentum investing is when a sector dips sharply and recovers just as abruptly. Say that the tech industry suddenly drops, so momentum investors move their money over to energy stocks. “If that reverses very quickly, and tech again leads with the portfolio sitting in energy stocks and non-tech … then the momentum strategy will be hammered because it’s at energy when tech is leading back the rise,” Nestor says. In this situation, you’re not really losing money per se, but underperforming relative to the overall market.