In the market, there are two schools of thought about investing. Warren Buffet popularized the first one -value investing. Buffet strongly advocates investing in companies with solid fundamentals having good cash flows but trading at lower PE. He believed that the market would correct the anomaly over the long term, resulting in an increase in the stock price and generating higher returns.
Richard Driehaus popularized the second school of thought. He is also known as the father of momentum investing strategy. Driehaus believed investors could make more money riding the trend in the stock market instead of staying invested for the long term. For example, he said, if a trend gets confirmed in the stock price, it will continue in the short term. In other words, you can make money by buying high and then selling at an even higher price and vice versa.
Yet, this investing style is not free from drawbacks. Before you consider such a strategy, we have a few things you must consider.
What is Momentum Investing Strategy?
Momentum investing is based on a simple strategy, using short-term market cycles to your advantage. For example, if a stock has established an upward trend or downtrend in the short term, it is most likely that the stock will continue the movement in the short term.
Generally, it’s about taking a position in stock once the trend is established and continuing to hold until the trend lasts. One can also short sell the stocks if the downtrend is confirmed. In both directions, you have a good chance to profit if you ride the momentum correctly.
However, momentum investing is easier said than done. The risks are more than value investing and require special skills like analyzing the technical charts to correctly determine the entry and exit points.
Five things to know before you consider Momentum Investing Strategy
1. Higher market volatility can lead to a high churn rate:
A momentum investing strategy is a short-term investment strategy that chases market movements to generate profits. It requires regular churning of the investment portfolio to adjust per the market condition, resulting in almost 10 to 20% replacement of portfolio stocks in a month. And, during a high volatility period, the percentage can go up even higher. This high churn adds to your trading costs and complexities.
2. Mind the capital gains tax:
All short-term trade attracts an STCG tax of 15% on the profits. In comparison, long-term investments (more than one year) attract an LTCG tax of 10% and are applicable only on the sale of listed securities which exceed Rs 1 lakh. Therefore, you need to be careful regarding tax on gains from momentum investing strategy and whether it is profitable over long-term investing.
3. Stocks don’t matter:
momentum investing strategy is not for you if you always prefer to invest in good-quality stocks. In momentum investing strategy, the pedigree of stocks doesn’t matter. If the stock (whether a good or bad one) meets the objectives set for the momentum investing strategy, it’s a buy. You often pick stocks randomly in such a strategy. There is no thought put into the fundamentals of the stocks.
4. Momentum can underperform:
Yes, you heard that right. From time to time, momentum strategies can underperform just like any other equity investment strategy. It’s very normal and part of an investment cycle. For instance, the UTI Nifty200 Momentum 30 Index has been underperforming in the last year; however, the situation may not last long. If you extend time horizons, you can easily manage risks in investing instead of fighting it out daily to protect profits.
5. Difficult to attain 100% accuracy on momentum investing strategy:
Despite the best research and analysis of momentum trends, half of the stocks that enter the portfolio of momentum investing don’t make gains. A momentum investing strategy is not just about picking a stock and holding until the trend lasts. You must create a portfolio to make decent returns and not lose too much on underperforming stocks.
Disadvantages of Momentum Investing Strategy
There are a few drawbacks in momentum investing strategy that you should be aware of, like:
One-off events that impact stock trends: In momentum investing strategy, traders try to make money by predicting future price movements based on recent price action. However, there always exists a risk of a sudden trend reversal. For example, a government policy change announcement can instantly reverse the trend.
Time-sensitive: It requires you to monitor the market constantly, how the stock price moves, volume changes, momentum indicators, etc. If not hourly, daily monitoring of trades is required.
High turnover: You must frequently get in and out of trades based on market trends and development. It can result in higher trading fees and difficulty in tracking the performance of past and existing positions. Does momentum investing strategy make sense and is it sustainable?
For traders, momentum investing strategy makes sense as it helps to capture the large price movements, but it’s not suitable for long-term and passive investors. The most significant disadvantage for long-term investors doing momentum investing is losing long-term perspectives of stocks and missing out on substantial market rallies.
If you want to profit from the market’s momentum without going into the complexities, you can consider investing in momentum index funds or follow Nifty200 Momentum 30 Index. The index tracks the performance of the top 30 companies within the Nifty 200 index based on their normalized returns.
momentum investing strategy may be rewarding initially, but in the long term, it’s not sustainable. John C Bogle, the father of index investing, says it’s hard to beat the average market returns in the long term; therefore, taking additional risks in investment is not justifiable.
Also, you must have high-risk tolerance and the capacity to absorb losses if you plan to pursue momentum investing. However, if you don’t think you can afford such risks, consider long-term investments in building a well-diversified portfolio and creating sustainable wealth.
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FAQs on Momentum Investing
Is momentum a good investment strategy?
Momentum investing can be a compelling strategy for certain investors, as it involves capitalizing on the continuance of existing market trends. This momentum investing strategy is based on the premise that stocks or other financial instruments that have performed well in the past will continue to do so in the near future. One key advantage of momentum investing is its potential to generate significant returns during bullish market periods, as it exploits the tendency of winning stocks to keep rising. Moreover, momentum investing can provide clear signals for buying and selling, which can simplify decision-making. However, there are notable risks associated with this approach. Momentum investing can lead to higher volatility and drawdowns, especially during market corrections or bearish trends. It also often involves frequent trading, which can incur substantial transaction costs and taxes. Additionally, the success of momentum investing is contingent on rigorous and timely analysis, as delayed responses to market changes can erode potential gains. Therefore, while momentum investing can be effective, it requires a high tolerance for risk, diligent market monitoring, and a disciplined approach to managing trades and associated costs. Investors should carefully consider these factors and possibly combine momentum investing with other strategies to mitigate risks.
Who is a famous momentum investor?
A famous momentum investor is Richard Driehaus. He is widely regarded as a pioneer in the field of momentum investing. Driehaus founded Driehaus Capital Management and became well-known for his investment philosophy that focused on buying stocks with strong price momentum and selling them when their momentum waned. His approach deviated from the traditional value investing strategy by emphasizing the importance of capitalizing on market trends and the continuation of existing price movements. Driehaus’s success and his contributions to momentum investing have earned him recognition and respect within the investment community.
What are the risks of momentum investing?
While potentially lucrative, momentum investing comes with several risks that investors should consider. One major risk of momentum investing is high volatility, as momentum stocks can experience significant price swings, leading to substantial gains but also large losses. During market downturns or corrections, momentum stocks often suffer severe declines as investors quickly sell high-performing stocks to mitigate losses. Another risk is the frequent trading involved in momentum investing, which leads to increased transaction costs and potential tax implications, eroding overall returns. The strategy also heavily relies on the continuation of existing trends, which may not always persist, making it challenging to maintain profitable positions. Successful momentum investing requires precise timing and quick execution, as delayed responses to market shifts can result in missed opportunities or increased losses. Behavioral biases, such as chasing past performance, can lead to overconfidence and herd behavior, amplifying market inefficiencies and increasing risk. Additionally, liquidity risks are a concern in momentum investing, as some momentum stocks may have lower liquidity, making it difficult to enter or exit positions without significantly impacting the stock price. Understanding these risks is crucial for investors considering a momentum investing strategy, and it may be wise to combine momentum investing with other strategies to mitigate potential downsides.
How do I start momentum investing?
Starting momentum investing involves several key steps that require careful planning and analysis. First, educate yourself about momentum investing by reading books, researching articles, and following expert opinions to understand the principles and strategies involved. Next, select a brokerage account that offers low transaction fees, a robust trading platform, and tools for analysis, which are essential for managing the frequent trading inherent in momentum investing. Developing a clear strategy is crucial; define your criteria for selecting momentum stocks, typically focusing on stocks that have shown strong price performance over a specific period, such as the past 3 to 12 months. Utilize technical analysis tools to identify trends and determine entry and exit points. Indicators such as moving averages, Relative Strength Index (RSI), and MACD can help in analyzing stock movements. Additionally, consider using a diversified approach to mitigate risks and continually monitor your portfolio to adjust your strategy as market conditions change. By following these steps, you can effectively start momentum investing and take advantage of market trends to potentially achieve significant returns.
