What is Momentum Investing? How it works?

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Momentum investing refers to buying stocks as their prices rise with the expectation that their prices will continue to rise.

What is Momentum Investing?

Every investor knows that timing the market is next to impossible, especially during times of heightened volatility. However, there may be ways to ride the wave of positive sentiment associated with a stock, a sector, or even the market as a whole. This practice is known as dynamic investing.

While the principle behind value investing is “buy low and sell high”, you could say that aggressive investors “buy high and sell even higher”. Investors then take all the profits from their winners, sell their losers, and repeat the process with the next trending opportunity.

The concept of dynamic investing is widely attributed to fund manager Richard Driehaus, who had $13.2 billion in assets under management when he died in 2021. Driehaus described his strategy saying that “the dynamic investor believes that a stock that is high may even head higher. We rarely invest in stocks because it is cheap and hoping for a turnaround.”

How and why does Momentum investing work?

Several factors come into play when considering investing in momentum – after all, the very definition of momentum is the force gained by a moving object. Therefore, momentum is a continuous process. It differs from buy-and-hold investing because aggressive investors spot opportunities from short-term trends, like news events, earnings reports, or other factors.

It is also important to note that dynamic investing is not just about buying; selling is almost as important a component of the process, not only to offset losses, but also to magnify gains. At a pre-determined time, the Aggressive Investor will sell underperforming stocks and invest any proceeds in those that perform in order to amplify their appreciation.

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TheStreet Dictionary Terms

Usually, technical analysis comes into play with momentum investing. This involves analyzing chart patterns to identify stocks that have reached new 52-week highs or broken through resistance levels, or those that are seeing above-average volume.

Earnings season is prime time for aggressive investors: As companies report better-than-expected results, stock prices could rise on the news. And because earnings beat expectations, analysts could upgrade the stock, driving the price up even higher.

It is important to note that what goes up often comes back, quickly. So, stocks that experience extreme increases in stock prices could be volatile, such as small caps or penny stocks. Owning them during a period of market turbulence, such as a bear market, can create stomach-churning amounts of volatility. That’s why it pays to do your research, so you can understand the history of the stock and whether the risks you’re taking are worth the potential reward.

What is an example of a Momentum investment?

Take a look at the performance of PepsiCo (NASDAQ: PEP). In July 2022, the stock rose after analysts raised their 2022 price target for the soft drink maker, then the shares soared when the company announced it had bought a small drinks company energizers called Celsius in August 2022. Investors who entered at $164 would have enjoyed gains of 9.75% in less than three months.

The graph above shows the evolution of PepsiCo's stock price from mid-May to the end of August 2022.

The graph above shows the evolution of PepsiCo’s stock price from mid-May to the end of August 2022.

What are the risks associated with Momentum investing?

The potential for short-term profits may lead many investors to think that they too can be dynamic investors, but without a solid understanding of business fundamentals, in reality, they are just betting.

  • The biggest risk associated with momentum investing is that trends simply don’t last forever. How do you know when a trend has passed? Exiting a position too early or leaving too late can erode returns.
  • Costs should also be taken into account. Turnover, or the practice of entering and exiting stock positions, can be high with aggressive investing, so investors need to consider transaction costs, which can also erode profits.
  • Investors should also be careful about their choice of investment. When trading low volume stocks with low liquidity, the gaps between bid and ask are often large. A bid is the highest price a buyer is willing to pay for a stock, while an ask is the lowest price a seller is willing to accept. The difference between the two is known as the supply-demand spread. When the spread is wide, trading is inefficient.
  • Conversely, if an investor makes overly conservative short-term investments, such as choosing a low-volatility mutual fund, they may only see additional gains during their investment period. . Thus, it may simply not be profitable to use a momentum strategy when trading low-risk assets.

How do you choose stocks for long-term momentum?

This question doesn’t really make sense because momentum is defined by short-term trading, so if an investor is looking for long-term appreciation, they might consider investing in growth instead. Growth investing involves identifying young companies that have above-average earnings potential. In fact, Dan Weil of TheStreet.com says growth investing has taken over value investing in 2022, and the only way the scenario will change is if there’s another Fed pivot.

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