Introduction

When it comes to investing, the sheer number of investing strategies available is mind-boggling. Each strategy comes with its own pros and cons. One such strategy is momentum investing. Usually, any short-term movements in the market make investors skeptical. However, this strategy can offer returns by capitalising on the market’s momentum. As an investor, you can opt for securities that show growth potential but are believed to appreciate in the foreseeable future. Likewise, you should sell any securities you own if their growth potential is low. By doing this, you stand a chance to earn profits by leveraging the market’s momentum.

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Read on to learn more about momentum investing and its causes, types, and benefits.

Decoding Momentum Investing

Momentum investing encourages investors to capitalise on the market’s volatility. It essentially suggests investing in stocks when they are on an upward swing and selling when they begin to decline. Richard Driehaus popularised this concept, dubbed the father of momentum investing. Investors can make profits by buying high and then selling at even higher prices. The rationale of this strategy suggests that the market trajectory remains constant in the short term. This means that a stock that’s rising will rise while a falling stock will fall.

Here’s an example to help you understand how momentum investing works. Let us assume an investor purchases shares of a company trading at ₹100 per share worth ₹50,000. The shares show a 10% increase in one month. The investor can purchase 500 shares at the prevailing rates and earn from this continued upward swing. The share price peaks at ₹120 and then falls. After a month, the shares touch their ₹120 target and fall to ₹115 within a week. As per momentum investing, had the trader sold the shares at their peak price, the profit would be ₹10,000 (₹60,000-₹50,000). However, when the shares are sold at ₹115, the profit will be ₹7,500 (₹57,500-₹50,000). In either situation, the trader stands to make a profit. In the above example, two transactions were carried out; to buy shares when their price rose and to sell when it fell.

What Causes Momentum Investing?

Investors usually over-or under-react to market news, resulting in volatility. In turn, this throws the market into disarray. Market timing also causes momentum investing. For instance, when you receive news about a specific stock, you take a while to respond. When you realise the information is helpful, you act, and it builds momentum in the market. However, it is also believed that momentum thus created doesn’t last longer than 6-12 months.

A defining characteristic of this strategy is it doesn’t encourage you, the investor, to hold a position when the momentum begins to crash. Instead, you need to exit immediately and restrict any potential losses. The idea is to purchase when the market is rising and only hold until the upward trajectory continues. The moment it takes a downturn; you must exit your position.

Types of Momentum Investing

Here are the two types of momentum investing strategies.

• The time-series momentum investing strategy, also known as absolute momentum, compares an asset’s current performance to its past performance. Assets are usually ranked according to their performance in the previous year.
• The second type is known as cross-sectional momentum. In this, different shares are ranked based on their performance within a given period. Shares are normally grouped as the best and worst-performing ones in relation to one another within a specific timeframe.

Benefits of Momentum Investing

You can gain the following advantages using a momentum investing trading strategy.

• Your investment has the ability to outperform itself when momentum is identified properly after thorough screening. However, discipline is needed while investing to avoid unnecessary losses.
• Through this strategy, you can leverage market volatility to earn a profit, regardless of whether it is an upward or downward movement.
• When you use a time-series strategy for momentum investing, you can profit from a diversified portfolio, which can potentially offer profits quickly.

Conclusion

Momentum investing is a good strategy that has the ability to offer high returns. Before executing it, ensure you understand how the concept works. However, this time-intensive strategy is market-sensitive and can result in a high turnover in terms of execution fees. As with any other trading strategy, careful deliberation and research are needed before executing it. Consider your risk appetite and investment goals to make the most of momentum investing.

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