What is Momentum Investing?

Feb 19, 2024 By Triston Martin

Momentum investing is a strategy of buying your best-performing securities and selling your worst-performing securities without waiting for them to bounce back from any current lows.

Momentum investing aims to profit from the continuation of an existing market trend. Investors use this trading strategy to purchase already rising stocks and try to sell them when they appear to have peaked.

In the world of markets, momentum is the ability of a price trend to maintain itself over time.

History of Momentum Investing

Many people refer to the late Richard Driehaus, founder of the Driehaus Capital Management LLC, as the "father of momentum investing." He frequently operated on the principle of "buy high, sell higher."

While Driehaus made the approach popular, Narasimhan Jegadeesh and Sheridan Titman released the research that backed momentum investing in 1993. They discovered that momentum investing is an investment strategy (involving shorting recent losers and selling recent winners) that outperformed the market from 1965 to 1989.

How does Momentum Investing Work?

Compared to other investment strategies, momentum investing is quite complicated to understand.

It's simple to apply momentum investing techniques to your investment portfolio. Take time to measure, then evaluate all the stocks you had throughout that period.

Momentum investing entails going long on assets such as stocks, market ETFs, futures, and other financial securities displaying rising pricing trends. Conversely, momentum investing goes short on respective assets showing falling prices.

Momentum investing asserts that trends can last for a while and that it is possible to get profit by following a trend through to completion, regardless of how long that may be. For example, momentum investors who started trading on the American stock market in 2009 typically profited from an increase until December 2018.

In particular, the returns during the previous three to twelve months were a reliable predictor of how the stocks would fare.

Momentum Investing Methods

Momentum investing requires following stringent guidelines based on technical indicators that specify market entry and exit points for certain assets.

Technical analysts can employ a variety of momentum signals in momentum investing. The price rate of change (ROC), relative strength indicator (RSI), stochastics, and moving average convergence divergence (MACD) are some of the most often used.

Momentum traders typically use two longer-term moving averages, one slightly shorter than the other, as trading indicators. For example, some people employ 50-day and 200-day MAs. The crossing of the 50-day above the 200-day creates a buying signal. Whereas crossing the 50-day back below the 200-day creates a selling signal. Many momentum investors prefer even longer-term moving averages for indication purposes.

Another momentum investing approach entails rotating in and out of the sectors by price-based signals. This method goes long on the sector ETFs with the strongest momentum and short on the sector ETFs with the weakest momentum.

Cross-asset analysis comes into play in other momentum investing tactics. Some equities investors consider the Treasury yield curve a momentum indicator to enter and leave the equity market. A two-year yield trading above the 10-year yield is a selling indication, whereas a 10-year Treasury yield above the two-year yield is typically a buy indicator. Remarkably, the yields on two-year versus 10-year Treasury bonds affect stock markets and are frequently a good indicator of recessions.

Momentum Investing Returns

Few professional investment managers utilize momentum investing because they believe that picking individual stocks based on an examination of discounted cash flows (DCFs) and other fundamental criteria is a better way to outperform indices over the long term.

To monitor the success of momentum investing, you can look at the MSCI USA Momentum Index, which is intended to highlight stocks with rising prices. Let's take the example of a comparison of the MSCI USA Momentum Index's annual performance against both the S&P 500 and its parent index, the MSCI USA Index.

Past performance doesn't give a guarantee of future results. The MSCI USA Momentum Index outperformed the other two indices between 2008 and 2019. It is noteworthy that the index underperformed other indices in 2008, the year of the financial crisis. This shows that while momentum investing may not be successful at safeguarding capital during difficult times, it may contribute to growth during periods of strong stock market growth.

Is momentum investing a viable strategy?

If you're new in the investing sector, you may prefer to base most of your investments on other tactics. It is not only challenging, but it also employs an active investing method. It might be challenging to react fast to pricing changes while also managing the rest of your life.

The viability of momentum investment corresponds with broad market trends similarly, even if it may not be as closely related to fundamentals as a strategy like growth investing. Momentum investing performs very well when the economy is growing quickly.

On the other hand, Robert Nestor, the CEO of Qraft Technologies USA, asserts that momentum investors should avoid bumpy markets. He claims that the absence of price trends, especially at the sector level, will be detrimental to momentum investment.

When a sector declines suddenly, the returns also drop abruptly; according to Nestor, this is a bad trend for momentum investing. Consider that the IT sector suddenly experiences a decline, causing momentum investors to shift their money to the energy sector. According to Nestor, the momentum strategy will suffer because it's at the energy when technology is leading back the climb. "If it reverses rapidly, and technology again leads with the portfolio resting in energy stocks and non-technology, then the momentum investing approach will be hammered." You aren't losing money in this scenario but instead performing poorly in comparison.

Bottom Line

Momentum investing aims to profit from the market's current trends as they continue.

Momentum investing incorporates rigorous guidelines based on technical indications that determine when to buy and sell specific stocks in the market. Momentum investing is rarely used by professional investment managers, who usually depend on fundamental variables and value indications.

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