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?
and Venturing Into Early-Stage Growth Stocks.)
Drawbacks of Momentum Investing
Risk/Return Tradeoff: Like a boat trying to sail on the crests of waves, a momentum investor is always at risk of timing a buy incorrectly and ending up under water. Most momentum investors accept this risk as payment for the possibility of higher returns. (Find out more about risk versus return in Determining Risk And The Risk Pyramid and Modern Portfolio Theory: An Overview.)
High Turnover: High stock turnover can be expensive in terms of fees. Even though low-cost brokers are slowly putting an end to the problem of high fees, this is still a major concern for most rookie momentum traders. Despite the fees issue, momentum investors believe that it is better to minimize your losses by selling any stock at the first sign of weakness than to ride it down with the rest of the crowd.
Time Intensive: Momentum investors have to monitor market details daily, if not hourly. Because they are dealing with stocks that will crest and go down again, they need to jump in early and get out fast. This means watching all the updates to see if there is any negative news that will spook investors. Although some momentum investors claim to have a gut feeling about when a correction is coming, they still need to monitor all the regular information that other investors will be using. (To read more on this subject, see Trading On News Releases, What Is The Impact Of Research On Stock Prices? and Mad Money ... Mad Market?)
Market Sensitive: Momentum investing works best in a bull market. In a bull market, investors tend to herd a lot more. In a bear market, the margin for profit on momentum investing shrinks in accordance with increased investor caution.
Manager Dependent Strategy: The time-intensive and time-dependent nature of momentum investing makes it impractical for most investors. This leaves traders and portfolio managers to try their hands at it. If regular investors want exposure to momentum investing, they need to pick a fund manager. The fund manager will, in turn, expect compensation for this service, which will cut into to your returns. Furthermore, these returns aren't guaranteed - no matter how much your manager pockets. (To keep reading about managers, see Should You Follow Your Fund Manager?, Will A New Fund Manager Cost You? and Assess Your Investment Manager.)
Is it practical for you?
Momentum investing can work, but it is may not be practical for all investors. As an individual investor - a person without a direct link to a major exchange and all the time in the world - practicing momentum investing will most likely lead to overall portfolio losses. When you purchase a stock that is rising or sell a stock that is falling, you will be reacting to older news than the professionals at the head of momentum investing funds. They will get out and leave you and other unlucky folks holding the bag. If you do manage to time it right, you will still have to be more conscious of the fees from turnover and how much they will eat up your returns.
Momentum trading is not necessarily for everyone, but it can often lead to impressive returns if done properly. It takes severe discipline to trade in this type of style because trades must be closed at the first sign of weakness and the funds must be immediately placed into a different trade that is exhibiting strength. Factors, such as commissions, have made this type of trading impractical for many average traders, but this story is slowly changing as low-cost brokers take on a more influential role in the trading careers of short-term active traders. Buying high and selling higher is momentum traders' enviable goal, but this goal does not come without its fair share of challenges.