As an investor, you’ve likely heard the phrase, “Buy low, sell high.”
But what about, “Buy high, sell higher?”
That’s the basic premise of momentum investing. It’s a data-driven investment strategy for traders seeking to capitalize on improperly valued equities.
The goal is to buy high, sell at peak profit, and rid your portfolio of unwieldy money. Sappers as soon as possible.
Did you know? It’s unclear who “invented” modern momentum investing. One of the earliest examples is from the 1993 edition of the Journal of Finance. Researchers noted that investing in past winners and selling past losers would have generated “significant abnormal returns” between 1965-1989. Chicago-based fund manager Richard Driehaus formally recognized the idea in 2004.
- Momentum investing is a technical trading strategy that involves buying rising securities to sell at peak performance and selling (or short selling) losing securities.
- You can identify momentum stocks by a set of technical indicators, such as moving averages and trend lines, or invest in managed momentum ETFs.
- While momentum investing has been shown to meet or outperform investing benchmarks on paper, real-world gains are often reduced by investing costs, time spent researching, and long-term market performance.
Momentum Investing: What is It?
Momentum investing is one of the more technical trading strategies. It involves seeking out securities that under- or overperform against the broader market. The goal is to determine a security or fund’s price momentum and capitalize on continuing trends with certain indicators:
- Trend lines: lines drawn between two points on a price chart to determine a stock’s overall direction
- Moving averages: lines that enables traders to determine a stock’s overall movement while minimizing background noise from small, ultimately insignificant fluctuations
- The Average Directional Index (ADX): a popular momentum indicator that calculates the expansion or contraction of a security’s price range over time to determine the existence and strength of a trend
How Does Momentum Investing Work?
As a rule, momentum investors seek to rack up profits in short-term increments, rather than in the long haul. For instance, an investor may hold a stock for anywhere from 2 months to 3 years before selling. That’s compared to a long-term investor who may hold the same security for 2-3 decades or more.
Ideally, an investor will see long-term profits with a momentum strategy by augmenting their portfolio with high-performing securities as they rise, then selling them off when they start to lose value.
This approach assumes that investors over- or undervalue certain stocks, leaving room for investors to profit off price discrepancies. Instead of selling your highest-performing securities, you buy more of them, while selling off any assets that drop in price.
Momentum investing rejects the efficient-market hypothesis (EMH), which states that assets are accurately priced according to all available information. Instead, investors believe that growth stocks will continue to grow, while consistently losing stocks will continue to lose.
The Pros and Cons of Momentum Investing
As with all investing strategies, there are pros and cons.
Advantages to Momentum Investing
On paper, momentum investing often meets or outperforms benchmarks and markets worldwide. For example, the MSCI USA Momentum Index – which tracks stocks with rising prices – outperformed the S&P 500 nine times between 2007 and 2020. It also outperformed its parent index, the MSCI USA Index, nine times in the same period.
However, even the best-performing momentum funds don’t prove excessively profitable when subjected to long-term analysis. Here, we can see MTUM’s 10-year performance against the S&P 500 500 ETF Trust (SPY), NASDAQ Composite Index (COMP), and NASDAQ 100 Index (NDX):
As you can see, MTUM has outperformed SPY in the long run by a relatively small margin. At the same time, MTUM has underperformed against the NASDAQ for most of the last decade.
Long-term momentum ETF performance is why some momentum investors turn to individual stocks, rather than managed momentum funds. But this strategy, too, comes with its own set of challenges.
Disadvantages to Momentum Investing
For instance, momentum stock investing involves a lot of short-term trade strategies, such as shorting stocks or day trading. As such, the practice can come with higher trading costs than a buy-and-hold strategy.
Even investors who hold for months instead of weeks may find themselves spending a lot of time hawking the markets for the next big buy. With momentum investment, timelines can be incredibly short – days or weeks, instead of years.
This means that your future fortunes may slip through your fingers if you don’t keep a finger on which stocks are charging a bull run and which are falling behind the market. And the more technical indicators you adopt in your vetting strategy, the more time you have to spend sifting securities.
And keep in mind, when momentum stocks are profitable, it’s because they rise quickly – but they can fall just as fast.
Big Names in Momentum Investments
Stocks that fall under the “momentum” umbrella tend to change over time as trends and prices shift. While many momentum investors seek to identify previously unrecognized momentum securities for personal gain, not everyone has the time to extensively analyze every security they come across.
One easier way to get involved with momentum securities is to invest in a momentum-based ETF, such as:
- The iShares Edge MSCI USA Momentum Factor ETF (MTUM), one of the largest momentum funds on the market with $15 billion AUM. MTUM tracks the MSCI USA Momentum Index and invests in over 100 securities across multiple sectors on a market-cap weighted basis.
- The Invesco DWA Momentum ETF (PDP), currently the second-largest high momentum ETF with $1.8 billion AUM. It tracks the Dorsey Wright Technical Leaders Index, which includes around 100 U.S. companies with powerful relative strength characteristics. Because it trends toward medium-cap stocks, it’s slightly more volatile than large-cap funds.
- The SPDR Russell 1000 Momentum Focus ETF (ONEO), which tracks the Russell 1000 Momentum Focused Factor Index, making it a well-diversified, multi-cap ETF. The ETF currently holds just over 900 securities and boasts $285 million AUM.
But for those investors who prefer to handpick their stocks – without running a full analysis themselves – another way to get involved with momentum securities is to examine which stocks comprise momentum indices and ETFs.
For instance, the top 10 constituents of the MSCI USA Momentum Index include:
- Thermo Fisher Scientific
- Alphabet A stock (Google)
- Alphabet C stock (Google)
While many of these securities fall into other categories, they can all be classified as momentum securities by standard technical indicators.
Getting Started with Momentum Investments
If you want to adopt a momentum investing strategy – or just a few momentum securities into your portfolio – getting started with your current portfolio is fairly simple:
- Pick a time frame, such as three to six months or a year
- Assess the performance of the stocks you own over that time
- Sell the lowest performers at the end of your chosen time frame
- Invest more in the stocks that have seen high returns
Note that there is a significant difference in time cost (and real cost) between investing in momentum stocks and momentum ETFs. Maximizing your stock investment returns requires more research, more trades, and a constant finger on the market’s pulse.
But for more casual momentum investors, a generalized momentum philosophy can still generate returns that match (or exceed) standard indices. A less granular approach – such as investing in momentum ETFs or throwing money in when the overall market is performing well – allows you to benefit from positive volatility without sacrificing your weekends to watching the stock market.