What is Momentum Investing? A Comprehensive Guide to Understanding Momentum Investing

by Siddharth Singh Bhaisora

Published On July 6, 2023

In this article

Are you drawn to the stock market's seemingly endless game of numbers and strategies? Or perhaps you're curious about how some traders manage to stay ahead despite the constant ebb and flow of stocks? If your answer is yes to either, then welcome to the first blog in our series where we'll delve into various investing strategies. We begin with the intriguing concept of momentum investing - a strategy that, interestingly, goes against traditional investment wisdom. So let's dive in and explore!

Understanding Momentum Investing - What is it?

Ever heard of Newton's first law? The one that states, "An object at rest stays at rest, and an object in motion stays in motion unless acted upon by an external force." Interestingly, this law isn't exclusive to physics; it's the principle underlying momentum investing. When a stock's prices are rising, momentum investors expect the upward trend to persist for some time, making it an exciting investment concept to explore.

Typically, conventional wisdom suggests the key to profitable trading lies in buying low and selling high. Momentum investing, however, proposes a different approach – buy high and sell even higher. Now, that's quite a paradigm shift, isn't it?

Methodology Behind Momentum Investing

Momentum investors tend to gravitate towards stocks that are already on a rise, often without deep concern for the company's fundamental values or structure. Instead, their focus is primarily on the performance, hoping to ride the wave of positive sentiment associated with a stock, a sector, or even the entire market.

This practice of capitalizing on the current market trends to make investments is what sets momentum investing apart. The basic strategy involves investing in companies that are escalating in value, then selling them after they peak and start to decline. This implies that momentum investing is all about aligning your investments with the direction of the share price momentum.

In this context, the market wisdom for momentum traders transforms from "buy low, sell high" to "buy high and sell even higher." A momentum trade typically concludes when a stock loses momentum and starts to fall, at which point the investor exits that stock and reinvests the capital in new stocks using the same strategy.

Momentum investing is a fascinating strategy that subverts traditional investing techniques. It can be likened to surfing where one rides the wave, rather than battling against it. Despite its appeal, it is not without its risks and rewards, just like any other strategy. As we delve deeper into this series, our goal is to arm you with the knowledge necessary to ascertain if momentum investing suits your investment style.

One of the most critical questions we face is how to identify momentum in a stock. Luckily, there are various momentum indicators available to assist in selecting stocks rich in momentum. But let's save that discussion for our future articles. In the meantime, keep in mind that every investment strategy is distinct, with its unique allure and potential pitfalls. Understand your strategy of choice thoroughly before you take the plunge. Until then, may you always ride the wave of market momentum!

A Brief History of Momentum Investing

Momentum investing has garnered considerable interest in recent times, with its roots tracing back centuries. This strategy is grounded in the belief that stocks with a history of good performance will likely continue doing well, while underperforming stocks will probably continue to slump. Let's take a brief look at the history of momentum investing.

Early Practitioners of Momentum Investing

In 1838, James Grant spoke about David Ricardo, a renowned English political economist who amassed substantial wealth from trading bonds and stocks in the late 18th and early 19th centuries. Ricardo's successful investment approach was underpinned by three pivotal rules: "Never refuse an option when you can get it," "Cut short your losses," and "Let your profits run on." These rules form the cornerstone of momentum investing.

Several renowned Wall Street figures have adopted momentum and trend-following methodologies, making it one of the most long-standing investment strategies. Among these figures, Charles H. Dow, founder of the Wall Street Journal, co-creator of Dow Jones & Company, and architect of the Dow Jones Industrial Average, made observations about the trend-following nature of stock prices. Dow noted that stocks on the rise are likely to continue growing, while those on the decline are likely to keep falling. His observations led to the creation of the Dow theory, which highlights the importance of identifying trends for successful investing.

Jesse Livermore, a successful market speculator in the early 20th century, held the view that the real wealth lay in understanding the market's primary movements rather than individual fluctuations. Between the 1920s and 1960s, several individuals such as Richard Wyckoff, George Chestnutt, Richard Donchian, Nicholas Darvas, and Jack Dreyfus made significant contributions to momentum investing, utilizing techniques such as relative strength analysis, moving averages, BOX theory, and investing in stocks hitting new 52-week highs.

Momentum investing continued its journey in the 1980s, with Richard Driehaus as one of its key proponents. In an interview featured in Jack Schwager's "The New Market Wizards," Driehaus articulated that wealth creation happens by purchasing high and selling at even higher levels. He strongly favored investing in stocks that had already demonstrated positive movements and had a high relative strength, indicating they were sought after by other investors.

This concept gained popularity in the 1990s when scholars Jagdish and Titman revealed in their studies that high-performing stocks often outperformed low-performing ones from the past. They also discovered that momentum was a recurring and widespread phenomenon that could be harnessed to generate superior returns.

Future of Momentum Investing

Initially, momentum investing involved a simple buy-and-hold tactic where investors bought high-performing stocks and held onto them, hoping to continue riding the momentum. As the strategy evolved over time, variations like "relative momentum" or "cross-sectional momentum" emerged. This variant involves buying stocks that have outperformed others within the same industry or sector, indicating that there will always be some stocks performing better than their peers, regardless of the overall market trends.

Another form of momentum investing is the "time-series momentum." This strategy requires buying assets that have done well over a specified timeframe (e.g., the last 12 months) and shorting assets that have performed poorly over the same period, aiming to exploit persistent trends.

The future of momentum investing looks promising due to the following reasons:

  1. Data Availability: Technological advancements have made vast amounts of data available to investors, enabling them to identify trends and patterns to spot momentum opportunities.

  2. Strategy Evolution: As momentum investing continues to evolve, unique variations enable investors to leverage momentum in different ways, increasing the strategy's flexibility.

  3. Behavioural Finance: As the study of how investor behavior impacts market trends and momentum gains traction, investors can better identify and exploit momentum opportunities.

  4. Low-Cost Investing: With the rise of passive investing and affordable investment options, investors can easily and cheaply build momentum-based portfolios, making momentum investing accessible to a wider audience.

Pros and Cons of Momentum Investing

A concern for some is that pure momentum strategies don't consider a company’s fundamentals. However, it's much like driving a car; you don’t need to understand the details of hydraulics and engineering to benefit from the vehicle. Similarly, momentum investors don't need to thoroughly understand a company's inner workings to potentially profit from a rising share price.

However, a section of investors adopts a hybrid approach, where they use momentum strategies to identify opportunities, and then apply fundamental analysis to finalize on the stocks they believe have the most potential.

Identifying Momentum in Stocks

Momentum investing is undoubtedly an intriguing concept that defies traditional investing norms. It's like surfing, where the surfer rides the wave rather than fighting against it. However, like all strategies, it has its own risks and rewards. As we journey further into this series, we hope to equip you with the knowledge you need to decide if momentum investing is the right strategy for you. Stay tuned for more insights in our upcoming blogs on investing strategies.

The million-dollar question is, how do we determine if there's momentum in a stock or not? Fortunately, several momentum indicators can help us analyze and select momentum-rich stocks. But that's a topic for another day. Stay tuned for the next blog in this series where we'll explore these indicators in detail.

Remember, every investment strategy has its unique charm and potential pitfalls. Make sure you fully understand the approach before you dive in. Until then, may the market momentum always be in your favor!

Learn more about the trending Wright Momentum Portfolio. Be sure to check out the next article in this series: Why Momentum Investing?

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