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On paper, momentum investing seems less like an investing strategy and more like a knee-jerk reaction to market information. The idea of selling losers and buying winners is seductive, but it flies in the face of the tried and true Wall Street adage, "buy low, sell high." In this article, we'll look at momentum investing and try to test its validity as an investing strategy.
The Father of Momentum Investing
Though not the first momentum investor, Richard Driehaus took the practice and made it the strategy he used to run his funds. His philosophy was that more money could be made by "buying high and selling higher," than by buying underpriced stocks and waiting for the market to re-evaluate them. Driehaus believed in selling the losers and letting the winners ride, while re-investing the money from the losers in other stocks that were beginning to boil. Many of the techniques he used became the basics of what is now called momentum investing.
Precepts of Momentum Investing
Momentum investing seeks to take advantage of market volatility by taking short-term positions in stocks that are going up and selling them as soon as they show signs of going down, then moving the capital to a new position. In this case, the market volatility is like waves in the ocean and a momentum investor is sailing up the crest of one, only to jump to the next wave before the first crashes down again. A momentum investor looks to take advantage of investor herding by leading the pack in and then being the first one to take the money and run.
Benefits of Momentum Investing
Momentum investing can be very profitable. For example, if you buy a growth stock that rallies from $10 to $15 on some glowing analyst reports and get out before the correction, you'll earn a profit of 50%. This is not the annualized return, but the return from a position that may have been only a week or a month old. The speed at which an investor could potentially make a pile of money is staggering. (To learn more about growth stocks, see Is Growth Always A Good Thing?
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