Introduction to Momentum

Momentum investing is a strategy used by investors to capitalize on the continuance of existing trends in the market.

Unlike other investment strategies that focus on valuation or long-term growth potential, momentum investing relies primarily on the movement of stock prices.

In essence, momentum investors buy stocks that have been increasing in price and sell them when they appear to have peaked, aiming to exploit the tendency of stocks to continue to move in the same direction because of market sentiment, investor behavior, and other factors.

To understand momentum stocks, it is crucial to grasp the basic premise that these stocks are chosen based on their recent performance history.

A momentum stock is typically one that has shown a significant upward trend over the past few months or even years, regardless of the company’s fundamentals.

This approach is grounded in the belief that stocks which are moving significantly in one direction will continue to move in that direction in the near term.

This strategy is distinctly different from value investing and growth investing.  Value investing involves buying stocks that are currently undervalued in the market. Value investors look for stocks that are trading for less than their intrinsic values and wait for the market to realize the true value of these stocks.

On the other hand, growth investing focuses on companies that exhibit signs of above-average growth, even if the stock price appears expensive in terms of metrics like price-to-earnings ratio. Growth investors are primarily concerned with the company’s future potential and earnings growth.

Instead, momentum investors focus on the stock’s recent price trends as a signal for its future movements.

This strategy can be risky, as it assumes that large increases in stock price will continue, which isn’t always the case. Moreover, momentum stocks can be quite volatile, and the momentum can reverse suddenly due to changes in market conditions or investor sentiment.

The rationale behind momentum investing lies in behavioral finance, which suggests that markets are not always efficient and that investors often make decisions based on emotions and biases rather than rational analysis.

For example, investors might be influenced by the herd behavior, buying stocks simply because others are buying and driving the price up, which in turn attracts more buyers. This self-reinforcing mechanism can drive prices up further, creating momentum.

However, momentum investing requires careful timing and active management. Since the strategy involves riding the wave of existing trends, momentum investors must be vigilant and ready to exit their positions before the trend reverses. This requires constant monitoring of market conditions and the ability to act quickly on the information.

While value investors seek undervalued stocks and growth investors look for companies with potential for future growth, momentum investors focus on stocks that are currently showing strong price trends.

The success of momentum investing depends largely on the ability to correctly time the market and manage risks associated with sudden reversals in stock price trends. As with any investment strategy, it is important for investors to understand their own risk tolerance and investment goals before choosing to pursue momentum investing.