Momentum Investing, A High Risk Strategy, Suddenly Popular Again
This popular investment strategy is now back in favor with investors.
You might have heard of this in the news or from other investors. Many people seem to be discussing momentum as an investment strategy. Not least because it has given a 30% + returns in 2023 so far. Let us look at this strategy in a little detail.
What is Momentum Investing ?
Some equate it to surfing, catching a wave.
It is about making the most of existing momentum in the market. Something that is going up will continue to go up, till it doesn’t.
When you spot a stock that has started trending upwards, you buy it and stay with that stock till it stops going up. Then you jump on to the next wave.
This sounds simple and it actually is. But like any simple strategy it requires a lot of effort to get right.
Where did this start ?
There are a few potential sources of where this got attention and became popular.
Narasimhan Jegadeesh and Sheridan Titman published a study on the profitability of momentum strategies in 1993.
Then there is Richard Driehaus who is credited with being the father of momentum investing. He used this strategy to run his funds. His philosophy was that it pays more to buy high and sell higher than to look for under-valued stocks.
There was a paper by AQR capital management, which studied the impact of momentum investing over a 100 years.
All in all, these factors led to the strategy becoming very popular in the 90s.
So, how do you implement this in real life?
There are a couple of ways you could execute this strategy yourself. You could keep a close eye on markets and see where stocks are making breakouts and buy them. Stick with them till the trend slips.
The idea is to be agnostic of fundamentals. Do not worry if you believe in the philosophy, strategy of the company or not. If it is going up you buy, when it stops you sell.
This means being aware of trends, sometimes spotting them before they become a trend.
For those of us, who invest on the side and have a full time occupation, there has to be a simpler way.
Yes, there is the index. NSE has a momentum index – Nifty 200 momentum 30. This covers the top 200 stocks of the Nifty and picks out the 30 stocks with the most momentum. The list is refreshed every 6 months.
If you look at the performance over the last year momentum has done well compared to the Nifty 50 and Next 50.
There are mutual funds too. Though there don’t seem to be too many of these. The ones I found seem to track the momentum index, rather than having their own momentum strategy.
Finally, you could use a Portfolio Management Service (PMS) too. If that is something that works for you.
Does this really work?
Well there are reams written about this, you should do your own research. My conclusion is that this works when the market is in a bull trend. If there is some volatility and the market is bullish, then momentum works quite well.
When the market is bearish this strategy seems to backfire.
The Value Investor will scoff at Momentum, the numbers however do hold their own weight.
It is important to understand the nuances and be willing to sit out longish periods. Especially the bearish cycles in the market.
The market is excited about the current 30%+ returns from Momentum. But let us not forget that for the 18 months before ’23 returns from momentum were flat or trailing the Nifty 50. Then there is the real risk of losing capital with such a strategy.
One sub-trend to be aware of also, is that this will work if there are a lot of momentum traders out there. If a stock breaks out and many investors spot that, they could all jump on to it. This will automatically push the price, making it a self-fulfilling cycle. The same can happen on the way down, selling pressure could build up fast. So large participation in the market will be a double-edged sword.
Needless to say, a momentum investor has to look at stocks that are liquid. If there isn’t enough liquidity then you could get stuck with the stock hitting circuits. This will not let you exit on the way up or down.
What are the down sides?
The most obvious one is that you spot the wrong trend or you continue to think there is a trend when there isn’t. Since you want to profit from volatility there is the possibility of losing due to volatility.
You need to have the stomach to bear a few losses in this strategy. You also need to be objective to buy or sell a stock based on data only with no connection to fundamentals.
There will be periods when the market is flat or bearish and this strategy will not pay.
Costs. Since you will be buying and selling stocks on a regular basis, there is a high cost of engaging with this strategy. Unless you invest in an index fund. But an index which refreshes every six months might lose out on shorter momentum swings.
Like any investment strategy that is based on market movements and volatility , this one too has it’s positives and negatives. Tread in to this strategy with caution. When things are going well, everything seems rosy, be aware of the thorns just below that rose.
Summary
- Momentum is a strategy that has been in play for many years
- Momentum strategy requires a lot of effort, regular knowledge and monitoring of the market
- There are mutual funds, index funds and PMSes that you can use for momentum investing as well
- It seems to work most effectively during a bull period and can be flat or negative during a bear period
This article is for informational purposes only. It should not be considered Financial or Legal Advice. Not all information will be accurate. Consult a financial professional before making any significant financial decisions.
