Momentum Investing

Momentum Investing is an investment strategy that bets on the continuation of existing market trends. The core idea is simple and alluring: winners keep winning, and losers keep losing. Momentum investors buy stocks or other assets that have shown strong price performance in the recent past (typically over the last 3 to 12 months) and often sell, or Short Sell, assets that have been performing poorly. This approach is the polar opposite of the contrarian nature of Value Investing, which seeks to buy undervalued assets that are currently out of favor. Instead of digging into a company's financial health to determine its Intrinsic Value, momentum investors are essentially “trend followers” who focus on market sentiment and price action. They believe that the upward or downward momentum of a stock's price will persist for some time. This strategy is heavily rooted in Technical Analysis and market psychology, rather than the Fundamental Analysis that underpins a value-based approach. It’s about riding the wave of popular opinion, not about owning a piece of a great business at a fair price.

If markets were perfectly efficient, momentum shouldn't consistently work. Yet, academic research has identified it as a persistent market anomaly, or factor. The reasons are believed to be more psychological than financial.

Human psychology plays a massive role in driving stock prices, often leading to trends that can be exploited.

• The Herding Effect: People are social creatures. When a stock starts rising, it attracts attention. As more investors jump on board, they push the price even higher, creating a self-fulfilling prophecy. This is often driven by a “fear of missing out” (FOMO).
• Slow Reaction to News: Investors can be slow to react to good (or bad) news about a company. Initial positive news might cause a stock to rise, and as more investors gradually digest the information, the upward trend continues for months.
• Confirmation Bias: Once an investor buys a rising stock, they tend to seek out information that confirms their decision was a good one, while ignoring negative signals. This collective bias helps fuel the stock's continued ascent.

Professional money managers can also contribute to momentum. For example, some portfolio managers engage in “window dressing”—buying recent top-performing stocks near the end of a quarter to make their holdings look more impressive to clients, further driving up the prices of those winners.

A momentum strategy is dynamic and requires constant monitoring. It's not a “buy and hold” affair.

1. The Look-Back Period: An investor first defines a “look-back” period to identify the winners. This is commonly the past 3, 6, or 12 months. They rank stocks based on their performance over this period.
2. The Holding Period: The top-performing stocks are then purchased and held for a predetermined “holding” period, which might be a few weeks or several months. The expectation is that the momentum will carry forward during this time.
3. The Rebalancing Act: At the end of the holding period, the process is repeated. The portfolio is re-evaluated, old “winners” that have lost steam are sold, and a new batch of top performers is bought. This constant buying and selling leads to very high portfolio Turnover, which in turn racks up Transaction Costs and can trigger significant tax bills.

From a value investor's standpoint, momentum investing is a fundamentally different—and often riskier—game. While a value investor thinks like a business owner, a momentum investor acts more like a stock renter, only interested in its short-term popularity. The primary dangers of momentum investing are:

• The Momentum Crash: Momentum works until it doesn't. Trends can and do reverse, often violently and without warning. When sentiment shifts, the same herding behavior that drove prices up can cause a stampede for the exits, leading to a swift and brutal crash in high-momentum stocks. It’s like a game of musical chairs; it's fun until the music stops.
• Buying High: The strategy explicitly involves buying what is already expensive and has run up in price. This means you are often buying into the hype, which is a precarious position to be in. The greatest risk in investing is paying too high a price, and momentum strategies systemically encourage this behavior.
• High Costs and Complexity: Successful momentum investing requires discipline, a systematic approach, and a stomach for volatility. The high turnover also means costs can eat away at returns, making it a difficult strategy for the average individual investor to execute profitably over the long term.

In conclusion, while momentum is a recognized market factor, it's a strategy built on skating on thin ice. It relies on predicting the psychology of the crowd, a notoriously fickle endeavor. For the patient, long-term investor, focusing on the durable value of a business remains a far more reliable path to building wealth.