Momentum investing is a popular investment strategy that focuses on the continuation of a prevailing market trend. It relies on the principle of the continuity of an upward trend.Strong upside trends continue-up, while those with a decline are further expected to decline. While most investors attempt to “buy low and sell high,” the investor who uses momentum does just the opposite: buying high and selling even higher. They do this by riding the waves of stock movements, hoping to make a gain as a result of changes in prices over time.
In this blog, the details of momentum investing will be elaborated on, how to construct the best momentum portfolio, what kind of tools and strategies are implemented, and also how this investment style has behaved over time.
What is Momentum Investing?
Momentum investing involves purchasing assets (such as stocks, commodities, or bonds) that show upward price momentum and selling assets that show a downward trend. Investors employing this kind of strategy believe that once the trend has been established, it’s likely to prevail over a length of time.
Momentum may take one of two forms:
- Upward Momentum: When the trend is upward, meaning stocks or assets are appreciating, indicating a good time to buy.
- Downward Momentum: A trend in which stocks constantly lose their value over time, becoming candidates for short selling.
Momentum investing relies a great deal on technical analysis, which evaluates past price data and predicts trends of future price movements.
Key Ingredients of a Momentum Portfolio
Some of the key variables for constructing the best momentum portfolio are mentioned as under:
1. Stock Selection
Momentum portfolios are typically composed of high-performing stocks. The common technique in this regard involves selecting those types of stocks that have exhibited the largest price increase within a unit period of time, which is usually considered to be either six or a period of twelve months. These types of stocks are expected to continue the momentum or further establish their performance.
2. Risk Optimization
Momentum investment can be intrinsically risky, as it depends on short-term price movements and market volatility. In most cases, investors use sophisticated techniques to build an optimal risk-reward allocation. These will involve adjusting exposure to assets based on historical performance, volatility, and correlation with other portfolio components.
3. Advanced Forecasting Tools
AI technology has been instrumental in momentum investing, more so in recent years. AI-based forecasting models make investors capable of predicting market trends and regime changes for a better understanding of situations when one needs to get into or out of a position.
4. Diversification
It would also be essential to point out that diversification is one of the mainstays of momentum investing. This essentially means spreading investments across different sectors and asset classes in order to reduce risk while keeping the potential for high returns.
5. Systematic Deallocation in Risky Markets
Momentum investing works best in strongly trending markets. The more risky or uncertain the market, one should have a systematic approach toward deallocation.
Technical Analysis Tools for Momentum Investing
Some of the most popular indicators include:
1. Moving Averages
The moving averages help an investor smooth out the oscillation in price and locate the true trend. When a stock is trading above its moving average, it signals upward momentum, while below indicates downward momentum.
2. Stochastic Oscillator
This indicator compares an asset’s current closing price to its range over a specific period. A stochastic oscillator reading above 50+ means upward momentum, while a reading below 50 means a downtrend.
3. Average Directional Index (ADX)
The ADX is an indicator used to discover the existence of a trend, as well as the strength of that trend. For example, ADX readings above 25 imply a strong trending market, but the readings below 25 imply a non-trending one-a directionless market.
4. Moving Average Convergence Divergence (MACD)
MACD works to help the investor spot reversals in trends by analysing the relationship between two moving averages. It is many times used to pinpoint the optimum times of entry and exit from a trade.
Advantages of Momentum Investing
Momentum investing has numerous advantages for an investor who wants to capture the prevailing short-term price direction.
• Profitability:
Well-tried momentum investing can yield returns considerably higher than from conventional buy-and-hold strategies.
• Market Volatility:
Momentum strategies will work best when the market is volatile. At this time, fluctuations in price therefore create a perfect ground for opportunistic returns.
• Behavioural Exploitation:
The momentum investors typically profit from inefficiencies created in the market by other participants’ behaviour biases through either herd mentality or emotional decision-making.
Risks with Momentum Investing
Like any other investment strategy, momentum investing has its potential pitfalls. Ideally, investors should be aware of what these risks are to manage their portfolios more effectively.
• Focus on the Short Run:
Momentum investment requires one to frequently change the investment portfolio. This can lead to higher transaction costs and increased tax obligations.
• Volatility:
While volatility can be beneficial, it also introduces risk. Sudden market reversals can lead to significant losses if not anticipated properly.
• Overcrowding:
If too many investors invest in a single momentum strategy, then over-investing becomes a problem and may lead to lesser returns because the prices might become artificially inflated due to too much demand.
The Performance of Momentum Investing
Momentum is one such investment strategy that has proved its success on a global as well as Indian basis for a considerable time. For instance, in India, the NIFTY 200 Momentum 30 Index has outperformed the traditional indices of NIFTY 50 and NIFTY Midcap 150 over the years. In many instances, momentum portfolios have outperformed buy-and-hold strategies with higher returns and over shorter horizons.
On the other hand, momentum strategies can also result in poor returns if there is a market downturn or a very volatile period, such as some quite dramatic declines in performance observed by funds following strategies of this nature during the financial crisis of 2008 and 2020.
Endnote:
In fact, momentum is one of the most exciting investment strategies when one wants to optimise returns within a short period. In fact, it’s actually quite possible to hold a momentum portfolio that captures upward trends with diminished risks, if one is able to concoct the right blend of technical analysis indicators for risk management with AI-powered forecasts.
For those looking at a complete passive play on momentum investing, Wright Research has put together the Wright Momentum Smallcase-a strategic portfolio of stocks that aims to ride the upward tide in their performance.
The Momentum investing strategy, correctly executed under the right discipline and with the right toolkit, can indeed be an almost overwhelming advantage in today’s fast-paced financial markets. Advanced investor or fledgling investor, it could well prove the missing ingredient in momentum strategies that will unlock greater returns for your best momentum portfolio.