Why Momentum Investing?

by Sonam Srivastava

Published On Feb. 12, 2023

In this article

Momentum works.

Momentum investing is a popular investment strategy that is based on the idea that stocks that have performed well in the past are likely to continue performing well in the future. This approach has been shown to be a historically successful investment strategy, and research has indicated that momentum investing can lead to higher returns than traditional value investing.

The success of momentum investing can be attributed to the persistence of stock returns, as well as to market inefficiencies that allow momentum strategies to exploit mispricings in the market.

Momentum investing is also a systematic approach, relying on data and rules to make investment decisions, which helps to reduce the impact of emotions and behavioral biases on investment outcomes.

While momentum investing is not without risks, it can provide investors with an opportunity to achieve higher returns while managing risk through diversification and other risk management techniques.

Momentum is a robust and persistent phenomenon.

Momentum is a robust and persistent phenomenon in the world of investing, meaning that it has been shown to persist over time and hold up well in different market conditions. Momentum investing has been shown to work across a wide range of asset classes and geographical regions, making it a versatile investment strategy.

The robustness of momentum investing can be attributed to its systematic approach, which helps to remove the impact of emotions and biases from investment decisions.

Additionally, the persistence of momentum is driven by the persistent behavior of market participants, who tend to follow trends and herd behavior. This leads to mispricings in the market that momentum strategies can exploit for higher returns.

Momentum is a systematic approach

Momentum is a systematic approach to investing, relying on data and rules to make investment decisions. A quantitative momentum investment strategy is built by identifying stocks that have outperformed the market in the past and using that information to make investment decisions.

To build a quantitative momentum investment strategy, investors typically start by gathering data on stock performance over a specified period of time. This data is then used to create a ranked list of stocks based on their past performance. The next step is to apply rules to determine which stocks to include in the portfolio, such as limiting the portfolio to a certain number of stocks or to a specific sector or market capitalization.

The importance of systematic and rule-based approaches to investing cannot be overstated. This helps to reduce the impact of emotions and biases on investment decisions and ensures that the strategy is repeatable and reliable.

The importance of diversification

Diversification is a key aspect of successful investing, and it is especially important in momentum investing. Diversifying a momentum portfolio across multiple assets and regions helps to reduce risk and increase stability. By spreading investments across a range of stocks, sectors, and regions, investors can reduce the impact of any single stock or sector-specific risks. This helps to ensure that the portfolio is not overly exposed to any one risk factor, which can result in more consistent and stable returns over time.

By diversifying the portfolio in this way, investors can increase their chances of achieving consistent returns, even during periods of market turmoil or economic uncertainty.

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The need for robust backtesting

The need for robust backtesting when developing a momentum investment strategy cannot be overstated. Backtesting is the process of evaluating a trading strategy using historical data to determine its potential for future success. Rigorous backtesting is crucial for developing a momentum investment strategy that is robust and can be applied in real-world conditions.

By testing the strategy on historical data, investors can determine its performance over time, identify any potential weaknesses, and make any necessary adjustments before putting the strategy into practice. This helps to ensure that the strategy is effective, reliable, and robust enough to withstand real-world market conditions.

In addition, backtesting can also provide valuable insights into the behavior of different markets and the persistence of momentum over time. Without robust backtesting, it is difficult to determine the true potential of a momentum investment strategy, and investors may be exposed to unnecessary risks.

The role of risk management

The role of risk management in momentum investing is crucial. Momentum investing, like any other investment strategy, is subject to market risks, and it is essential to manage these risks to ensure consistent and stable returns.

One effective way to manage risk when investing in momentum strategies is by using stop-losses. A stop-loss is a predetermined level at which an investor will sell a stock to limit their potential losses. This can help to reduce the impact of sudden market declines or individual stock price movements. In addition to stop-losses, there are other risk management tools that investors can use, such as diversification and position sizing, to manage risk and increase stability.

Diversification, for example, helps to spread investments across multiple stocks, sectors, and regions, reducing the impact of any single stock or sector-specific risks.

Position sizing, on the other hand, helps to determine the appropriate size of each investment based on the investor's overall risk tolerance and portfolio size.

Factors to Consider when Following Momentum Investing Strategies

Investors following momentum investing strategies are often drawn to buying high-priced or rising stocks. They tend to focus more on the company's ongoing performance or structure rather than its fundamental value. So what prompts investors & traders to pursue momentum? There are two primary reasons:

  • Bias: Drawing from behavioral finance, investors may show a bias towards a particular stock in the market. They may overreact or underreact to new information, creating pricing inefficiencies that momentum traders can exploit.

  • Timing: Some investors react slowly to new information but are quick to act once they decide to, contributing to the momentum of the stock. This catch-up behavior is part of why momentum investing is generally seen as a short-term strategy, often playing out over 6 to 12 months.

What should you consider when choosing a stock for momentum investing? These trading strategies usually depend on industry trends. For instance, in late 2021 tech stocks lost momentum and investors shifted their focus to energy stocks. 3 factors should be kept in mind:

  1. Momentum: One way to identify a stock with upward (or sometimes downward) momentum is by tracking its percentage change over a specified time period.

  2. Volatility: For momentum investors, volatility is gauged relative to the market and is quantified by beta. If the beta is 1, the stock's volatility matches the market's. A beta below 1 indicates less volatility than the market, and vice versa.

  3. Size: Studies suggest that small to medium-sized companies tend to outperform larger, established firms in momentum trading strategies.

For newcomers, momentum investing may seem like a straightforward strategy — simply following the curve. However, it's important to complement this approach with other strategies to enhance your investments. Momentum investing requires active engagement, responding to price movements. This may pose a challenge if you're not accustomed to active investing.

Be sure to check out the next article in this series Momentum Investing: Risk, Reward & Everything Else.

Ride the Momentum investing wave with Wright Momentum Smallcase and find the top trending stocks.
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