What Is Momentum Investing?

Momentum investing is one of the most popular strategies used by investors to make good returns from the stock market. Are you someone who is absolutely clueless about moment investing? No worries. In this blog, we delve deep into what momentum investing is, how it works, types of momentum investing, benefits, risks and much more.

What is momentum investing?

Momentum investing, in simple terms, is a strategy where the focus is on buying stocks with a strong performance in the market over a recent period and selling them when their momentum slows down. It is popularly known as a ‘buy high, sell higher’ approach. The whole idea of momentum investing is that stocks that have been performing well are likely to continue their robust performance in the near future as well.

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Example of momentum investing

Imagine that you are planning to buy a new bike. After researching, you get to know that a particular model is gaining rapid popularity. Its reviews have been amazing, it is winning awards and the number of people buying that model has been increasing day by day. After noticing the trend, you finally make up your mind to buy that bike with the expectation that its popularity will continue to rise. Due to the enormous popularity, you also hope that its resale value will remain high or even increase over time. 

Momentum investing also works in a similar manner. It’s all about buying stocks that are gaining momentum in the market. Here the objective is to benefit from the upward trend, in the same way that you benefit from owning the bike that is having huge demand and increasing value. Having said that, the popularity of a bike model can slide if a newer, better model is launched in the market. In the same way, a stock’s momentum can also slow down or reverse. An important aspect of momentum investing is to sell the stock before its momentum comes down. It is just like selling your bike when it is very much in demand rather than selling after its popularity fades.

How does momentum investing work?

The most important part of a momentum investing strategy is to identify stocks that are trending positively. The effectiveness of this strategy mainly depends on the following key indicators.

1. Price

The first and one of the most critical factors is price. Stocks with rapid price increases indicate that there is a strong momentum and the market sentiment is favourable. As a result, such stocks become the favourite of momentum investors.

2. Trading volume

The next key indicator is trading volume. If there is high trading volume in a particular stock, it signals that the positive momentum is gaining traction. 

3. Earnings growth

Last but not least, earnings growth is the next key indicator. Stocks that deliver robust earnings growth tend to maintain positive momentum. The reason is that strong financial performance attracts more investors.

To sum it up, momentum investors rely on price movement, volume, and earnings growth: the 3 key indicators to find stocks that hold the potential to continue their upward trend.

Types of momentum investing

There are different ways in which momentum investing can be applied, based on the investor’s choice and the type of investment vehicle.

1. Focus on individual stocks

A common method is to focus on individual stocks. It works in such a way that investors track and invest in those stocks that display strong momentum.

2. Momentum mutual funds

The next option is momentum mutual funds. Here, the funds are managed by professional fund managers who implement different strategies to pick high-momentum stocks. In the same fashion, momentum ETFs (Exchange-Traded Funds) are designed to track indices that consist of stocks with a robust price momentum. The best part of ETFs is that they provide an option to investors to diversify their portfolios while being very much part of the momentum-driven growth of specific sectors or markets.

Benefits of momentum investing

Curious to know the benefits of adopting a momentum investing approach? There are many, especially in markets that demonstrate a strong upward movement.

1. Capitalises on investor behaviour

When a stock or sector performs really well, it naturally attracts a large number of investors. As a result, it creates a feedback loop driving the stock prices further upward. This helps momentum investors cash in from the wave of growth by making potential gains.

2. Performs well in bullish markets

During times of rising markets, momentum investing tends to perform well. With the rise in stock prices and building up of momentum, investors who align themselves with these trends can benefit from the increasing returns.

3. Broader opportunities

Another major benefit of momentum investing is the broader opportunities it offers. Since momentum strategies do not limit themselves to any particular sector, investors have the luxury of choosing from a wide universe of stocks and markets. 

4. Diversification of portfolios

Momentum investing lets investors diversify their portfolios across various high-performing trends while focusing on momentum at the same time.

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Risks in momentum investing  

Momentum investing comes with its own share of risks.

1. Demands constant monitoring

One of the main risks is that it requires constant monitoring. Momentum investing demands investors to track trends closely and also to make quick decisions. It becomes challenging for those who lack expertise. Moreover, it is also time consuming. Due to these reasons, people may end up in missed opportunities or even in poor investment decisions in scenarios where trends reverse unexpectedly. 

2. Higher transaction costs

Frequent buying and selling ultimately leads to increased fees. This burns a hole in the pocket of investors as they have to make frequent adjustments, especially in volatile markets.

3. Dependent on market conditions

By now you know that momentum strategies thrive in rising or ‘expected to rise’ markets. That said, during times of market downturn, it becomes difficult to maintain momentum.

Who should consider momentum investing?

Momentum investing comes with the option of making higher returns by capitalising on market trends. Thus, it is best suited for growth-oriented investors with a higher risk tolerance. By carefully selecting well-performing stocks and monitoring their momentum, investors can optimize their portfolios for higher profitability.

Key takeaways

• Momentum investing focuses on buying stocks with a strong performance over a recent period and selling them when their momentum slows down
• This strategy depends on 3 key indicators: price, trading volume and earnings growth
• Momentum investing can be applied by focusing on individual stocks or through momentum mutual funds
• The major benefits of momentum investing are that it capitalizes on investor behaviour, performs well in rising markets, offers broader opportunities and portfolio diversification
• The main risks in moment investing: it demands constant monitoring, involves higher transaction costs and is dependent on market conditions

Parting Words

Momentum investing is an excellent investment strategy, as you know by now. However, if you want to reap the real benefits, an expert mentor should be there to guide you. Entri Finacademy, a leading finance education platform since 2022, offers all that and more. With over 9 million students and a SEBI-registered research analyst reviewing all the study materials, Entri offers an altogether different experience to its students. A team of highly experienced mentors and options to learn stock trading courses in several regional languages, including Malayalam, makes Entri Finacademy clearly stand out from the rest. To know more about Entri’s courses, click here.