Momentum investing

What Is Momentum Investing?

Momentum investing is an investment strategy that centers on the idea that assets which have performed well recently tend to continue performing well in the near future, and similarly, assets that have performed poorly tend to continue to do so. This approach falls under the broader umbrella of investment strategy within quantitative finance, relying heavily on the analysis of past price and volume trends rather than fundamental analysis. Proponents of momentum investing believe that market trends exhibit a certain persistence, allowing investors to capitalize on the continuation of existing price movements. This strategy aims to capture returns by buying "winners" and selling "losers," thereby riding the ongoing strength or weakness of particular securities. It is distinct from other methodologies like passive investing, as it involves active portfolio management and regular rebalancing.

History and Origin

While the concept of profiting from prevailing market trends has anecdotal roots stretching back centuries, the systematic study and popularization of momentum investing in academic circles are more recent. Early observations by figures like Charles Dow in the 19th century laid some groundwork by noting that stock prices in motion tended to stay in motion. However, it was the 1993 paper "Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency" by Narasimhan Jegadeesh and Sheridan Titman that provided significant empirical evidence for the profitability of momentum strategies in the U.S. stock market.⁷, ⁸ This seminal work demonstrated that strategies involving buying past winners and selling past losers generated significant positive returns over 3- to 12-month holding periods.⁵, ⁶ The research challenged the prevailing efficient market hypothesis, suggesting that market inefficiencies could be exploited. The observed "momentum premium" has since been extensively studied and confirmed across various asset classes and global markets, contributing to its recognition as a persistent market anomaly.⁴

Key Takeaways

• Momentum investing seeks to profit from the tendency of recent winning assets to continue outperforming and recent losing assets to continue underperforming.
• It is a quantitative approach that emphasizes price and volume trends over fundamental analysis.
• The strategy typically involves buying assets with strong upward price momentum and selling or shorting those with negative momentum.
• Academic research, particularly the 1993 study by Jegadeesh and Titman, provided significant empirical support for the existence of a "momentum premium."
• Momentum strategies are often associated with higher trading volume and turnover.

Formula and Calculation

Momentum in investing is typically measured by calculating an asset's past performance over a specific look-back period. A common approach for cross-sectional momentum involves comparing the total returns of various assets over a defined historical period, such as the past 3, 6, or 12 months, often excluding the most recent month to avoid short-term reversals.

The formula for calculating an asset's simple return over a period is:

Where:

• (R) = Momentum (Return)
• (P_1) = Asset price at the end of the look-back period
• (P_0) = Asset price at the beginning of the look-back period

For a portfolio construction, one might rank all investable assets based on this calculated return. A momentum strategy would then involve buying assets in the top quintile or decile (the "winners") and potentially selling or shorting assets in the bottom quintile or decile (the "losers"). This process often involves looking at return on investment (ROI) for various assets.

Interpreting Momentum Investing

Interpreting momentum in investing involves understanding that it is a relative strength concept. A stock's momentum is not just about its absolute price increase, but how that increase compares to other stocks or the broader stock market. High positive momentum suggests that an asset is currently in favor with investors and exhibits strong upward market trends. Conversely, negative momentum indicates that an asset is losing favor and experiencing downward price pressure.

Practitioners use momentum to identify potential entry and exit points for trades. A strong positive momentum signal might lead an investor to initiate a long position, while a weakening of momentum or a shift to negative momentum could trigger a sell decision. This interpretation is often used in conjunction with technical analysis indicators to confirm trends and manage risk.

Hypothetical Example

Consider two hypothetical stocks, Company A and Company B, at the beginning of the year.

• Company A: Started at $50 per share. Over the past six months, it has risen steadily and is now at $75 per share.
• Company B: Started at $100 per share. Over the past six months, it has fallen to $80 per share.

A momentum investor would calculate the six-month return for each:

• Company A Momentum: (\frac{$75 - $50}{$50} = 0.50) or 50%
• Company B Momentum: (\frac{$80 - $100}{$100} = -0.20) or -20%

Based on a simple momentum strategy, the investor would identify Company A as a "winner" due to its strong positive momentum and potentially consider buying its shares. Company B, being a "loser" with negative momentum, would be avoided or potentially sold short if the strategy allows. This simple scenario highlights the core principle of momentum investing: identifying and following the trend. Investors employing this strategy would continue to monitor the performance of Company A, expecting its upward trend to persist.

Practical Applications

Momentum investing has several practical applications across various financial domains. In active asset allocation, portfolio managers can use momentum signals to overweight sectors, industries, or geographic regions that are exhibiting strong relative performance. This can lead to dynamically shifting portfolios towards areas of perceived strength. For instance, during a bull market, a momentum investor might increase exposure to technology stocks if that sector is leading the market.

Furthermore, quantitative fund managers often build systematic momentum strategies that are entirely rules-based, relying on algorithms to identify and trade momentum signals without discretionary human intervention. This approach is a core component of quantitative analysis in finance. Momentum strategies are also used in constructing factor-based exchange-traded funds (ETFs) and mutual funds, which seek to capture the momentum premium as a distinct source of excess returns. The "Two Centuries of Momentum" research by Newfound Research highlights the strategy's historical robustness and application in constructing risk-managed portfolios.³

Limitations and Criticisms

Despite its historical empirical support, momentum investing is not without limitations and criticisms. One significant drawback is its vulnerability to sudden market reversals, often referred to as "momentum crashes." These occur when previously strong trends abruptly reverse, leading to significant losses for momentum portfolios. Such events can happen during periods of extreme market volatility, like the dot-com bubble burst or the 2008 financial crisis.

Another criticism revolves around high transaction costs and taxes. Momentum strategies typically involve frequent trading and high portfolio turnover as "winners" and "losers" change. This can erode potential returns, especially for individual investors subject to short-term capital gains taxes. Some argue that, after accounting for these costs, the actual profitability of momentum strategies diminishes.

From a theoretical perspective, the persistence of momentum challenges the efficient market hypothesis, which posits that asset prices fully reflect all available information, making it impossible to consistently achieve abnormal returns. Explanations for momentum often delve into behavioral finance, suggesting that investor biases such as under-reaction to new information or herding behavior may contribute to the phenomenon. However, these behavioral explanations are also subjects of ongoing debate.² Managing risk management effectively is crucial for any investor considering a momentum-based approach.

Momentum Investing vs. Value Investing

Momentum investing and value investing represent two fundamentally different approaches to identifying investment opportunities. While momentum investing focuses on buying assets that have demonstrated recent strong performance, value investing seeks to identify and purchase assets that appear to be trading below their intrinsic value.

The confusion between the two often arises because both are systematic investment strategies. However, their underlying philosophies are nearly opposite. Momentum investors "buy high and sell higher," while value investors "buy low and sell high." Historically, these two factors have shown a low, and sometimes negative, correlation, making them complementary in a diversified portfolio by potentially providing different sources of return at different times.¹

FAQs

What is the primary goal of momentum investing?

The primary goal of momentum investing is to generate positive returns by identifying and investing in assets that are already in an upward price trend, with the expectation that this trend will continue in the short to intermediate term. It aims to capture the continuation of market movements.

Is momentum investing a long-term strategy?

Momentum investing is typically considered a short-to-intermediate-term strategy, usually involving holding periods of 3 to 12 months. It focuses on capturing transient market trends rather than long-term fundamental growth, contrasting with buy-and-hold strategies associated with long-term diversification.

How does momentum investing differ from trend following?

Momentum investing is a form of trend following, specifically focusing on the relative strength of assets over a defined look-back period. While all momentum strategies are trend-following, not all trend-following strategies are strictly momentum-based; some might incorporate a broader range of signals or time horizons.

Can individual investors use momentum investing?

Yes, individual investors can implement momentum investing, often through momentum-focused exchange-traded funds (ETFs) or by following simple rules-based strategies to select stocks or other assets with strong recent performance. However, they should be aware of the higher transaction costs and potential for rapid reversals.

Is momentum investing always profitable?

No, momentum investing is not always profitable and can experience periods of significant underperformance, particularly during sharp market reversals or shifts from a bull market to a bear market. Like any investment strategy, it carries inherent risks and does not guarantee returns.