Too embarrassed to ask: what is momentum investing?
Momentum investing – the opposite of the “buy low, sell high” advice – is based on the observation that trends in the stockmarket can continue for longer than most investors expect.
How do you make money in the stockmarket? A common, if flippant, answer is: “buy low, sell high”. In other words, invest in companies that look cheap, and sell them if and when they get expensive.
How do you know that a company is cheap? There are many ways to value a company. But they mostly involve looking at its accounts. How much profit does it make? What are the assets it owns – from factories or shops, to brands and intellectual property – really worth? These are all sometimes known as “the fundamentals”.
But there’s another way to invest that doesn’t involve the fundamentals. In fact, it involves doing the opposite of the “buy low, sell high” advice. This is momentum investing. Momentum investing is based on the observation that trends in the stockmarket can continue for longer than most investors expect.
Share prices that are already rising can simply keep going higher, even if they look expensive. Meanwhile, companies whose share prices are collapsing can keep falling ever lower, regardless of how cheap they look on a fundamental basis. In other words, momentum investors buy stocks that are going up, and avoid (or even sell) those that are going down.
How do momentum investors decide when a trend is worth joining, and when it might be coming to an end? They generally use technical analysis. Technical analysis involves looking at charts of share prices and using various pattern-spotting methods to find promising entry and exit points.
Momentum investing does rather contradict the academic idea that the market is efficient. In theory, rational investors shouldn’t buy a stock simply because lots of other people are. And yet, in practice, several studies have shown that momentum investing works.
As with any investment strategy, momentum does not outperform all the time. You should view it as another way to diversify your portfolio. Of course, unless you are willing to spend a great deal of time drawing lines on charts and researching technical analysis techniques, it’s very difficult for an individual investor to replicate the strategy.
However there are now several momentum strategy funds available, which allow private investors to access the strategy without having to do it themselves. For more on those, subscribe to MoneyWeek magazine.