What Is Momentum Investing? How Does It Work?

What is momentum investing?

Any investor knows that it is virtually impossible to time the market, especially during periods of heightened volatility. However, there may be ways to join the wave of positive sentiment associated with a stock, an industry, or even the market as a whole. This practice is known as momentum investing.

While the principle behind value investing is ‘buy low and sell high’, you could say that momentum investors ‘buy high and sell higher’. Investors then take any profits from their winners, sell their losers and repeat the process with the next trending opportunity.

The concept of momentum investing is largely credited to fund manager Richard Driehaus, who had $13.2 billion in assets under management at his death in 2021. higher. We rarely invest in stocks because it’s cheap and we hope for a turnaround.”

How and why does Momentum Investing work?

There are several factors that come into play when considering momentum investing – after all, the definition of momentum is the force obtained by a moving object. Therefore, momentum is a continuous process. It differs from buy-and-hold investing because momentum investors see opportunities based on short-term trends, such as news events, earnings reports, or other factors.

It’s also important to note that momentum investing isn’t just about buying; selling is an almost equally important part of the process, not only to offset losses, but also to increase profits. At a predetermined time frame, the momentum investor will sell underperforming stocks and invest any proceeds in those who are working to increase their valuation.

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TheStreet Dictionary Terms

Usually, technical analysis plays a role in momentum investing. This includes analyzing chart patterns to identify which stocks have hit new 52-week highs or broken resistance levels, or which stocks are seeing higher-than-average volume.

Earnings season is an excellent time for momentum investors: As companies report better-than-expected results, stock prices may soar on the news. And as earnings beat expectations, analysts could upgrade the stock, pushing prices even higher.

It is important to note that what goes up often comes down quickly. So stocks with extreme price increases can be volatile, such as small caps or penny stocks. Owning these during a period of market turbulence, such as a bear market, can lead to stomach-turning amounts of volatility. That’s why it pays to do your research so you understand the stock’s history and whether the risks you’re taking are worth the potential reward.

What is an example of momentum investing?

Check out PepsiCo’s (NASDAQ:PEP) performance. Shares rose in July 2022 after analysts raised their 2022 price target for the soda maker, then shares rose when the company announced it had acquired a smaller energy drink company called Celsius in August 2022. Investors coming in for $164 would have enjoyed 9.75% gains in less than three months.

What are some risks associated with momentum investing?

The potential for short-term gains tempts many investors to think they can also be momentum investors, but without an understanding of the company fundamentals, they are really just betting.

  • The biggest risk of momentum investing is that trends just don’t last forever. How do you know when a trend is over? Leaving a position too early or leaving too late can affect returns.
  • Fees must also be taken into account. Turnover, or the practice of entering and exiting stock positions, can be high in momentum investing, which is why investors need to factor in transaction costs, which can also eat away at profits.
  • Investors should also consider their investment selection. When trading low volume, low liquidity stocks, there are often wide bid/ask spreads. A bid is the highest price a buyer is willing to pay for a stock, while an ask is the lowest price a seller is willing to accept – the difference between the two is known as the bid-ask spread. When the spread is large, trading is inefficient.
  • Conversely, if an investor makes overly cautious short-term investments, such as choosing a low-volatility mutual fund, they may only see incremental gains over their investment period. So it simply may not be profitable to use a momentum strategy when trading lower risk assets.

How do you choose stocks for long-term momentum?

That question doesn’t really make sense because momentum is determined by short-term trades, so if an investor is looking for long-term valuation, they might consider growth investments instead. Growth investing is identifying young companies with above-average earning potential. In fact, TheStreet.com’s Dan Weil says growth investment will have taken the lead over value investment by 2022, and the only way the storyline will change is if there’s still a Fed pivot.

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