Momentum Investing: Everything you need to know

Momentum investing has been an extremely popular trading and investment strategy among investors, experts and retail investors. And with good reason. After all, it picks stocks that are already on an upward trajectory. However, when market volatility is persistent like we have seen this year, with global supply disruptions, geopolitical conflicts, high inflationary pressures, and rising interest rates, you realise the strategy's vulnerability. But before we get too far ahead, let's learn more about momentum investing.

What is momentum investing?

In physics class, you would have learnt Newton's first law – "An object at rest remains at rest, or if in motion, remains in motion at a constant velocity unless acted on by a net external force." The same rule applies to momentum investing. So when the stock prices rise in the stock market, there is an expectation that the growth trend will continue for the next couple of months. And this is why it is deemed by many as an interesting investment concept.

Conventional wisdom will tell you to make a great trade, you need to buy low and sell high. But, of course, momentum investing defies this notion, with the aim being – to buy high and sell even higher.

So investors who practice these momentum investing trading strategies are encouraged to purchase shares that are priced high or a stock that is on the rise. Most are attracted to such shares. This is because they are not concerned with the fundamentals of the stock but rather with company structure or performance.

So why do traders chase the momentum?

Well, there are two simple explanations as to why an investor chases the momentum.

Bias: Taking a note from behavioural finance, this occurs when investors have a bias towards a particular share in the stock market. Often an investor is likely to overreact or under-react to information presented to them. During these times, pricing inefficiencies can emerge.

Timing: Investors that are initially slow to react when new information comes in are in a hurry to action and further drive the stock's momentum. This very nature of catching up with stocks is why momentum investing is always considered a short-term trading strategy, often playing out in 6 to 12 months.

So what to keep in mind when selecting a stock?

For momentum investors, their broader trading strategies, always relies on industry trends. That is why over the years, their strategies have concentrated towards energy stocks from tech stocks after they lost steam in late 2021. So, when it comes to momentum investing, these 3 factors should be considered.

Momentum: Another way to select a stock that is in an upward (or sometimes downward) momentum is by measuring its change in percentage over a defined time period.

Volatility: For momentum investors, volatility is measured according to the market and quantified by beta. So, if the beta is 1, then the stock's volatility is equal to the market. If it is below, then it is an indication that volatility is lower in the market and vice versa.

Size: Research has indicated small and medium-sized companies are likely to outperform larger, more established firms in momentum trading strategies.

For newbies, this seems like a solid investment strategy. After all, all you are doing is following the curve. But the truth is, you should rely on other strategies to boost your investments. For example, momentum investing requires you to be an active investor, where you react to price movements. This can be difficult if you aren't an active investor.