Momentum investing, a widely adopted investment approach, seeks to generate profits by capitalising on upward trends while steering clear of assets on a downward trajectory.
This investing strategy involves prioritising the purchase of assets experiencing upward momentum and selling them when indications suggest a weakening trend. The fundamental concept is rooted in the belief that trends exhibit persistence, implying that if a stock or asset is on an upward trajectory, it is more likely to continue rising than to abruptly reverse direction. Typically, momentum investors employ technical analysis techniques, examining charts and indicators like moving averages and the relative strength index (RSI) to pinpoint trends and potential entry or exit points. Beginners in the market often adopt this strategy based on insights provided by financial experts, whether online or offline.
Why do investors employ momentum investing?
In contrast to alternative investment approaches, momentum investing can be a relatively straightforward strategy to execute, particularly when compared to the complexities of fundamental analysis, which requires a thorough examination of a company’s financials and business outlook. This approach can yield substantial returns, particularly during bullish market conditions when trends are robust and enduring.
Momentum investors hold the belief that once a trend, whether upward or downward, takes shape, it is likely to persist for a certain period. Their strategy involves purchasing assets on the rise and divesting those on a downward trajectory, to capitalise on and profit from these trends.
Momentum strategies leverage investor psychology, specifically the effects of herd mentality and the fear of missing out (FOMO). When a significant number of investors perceive a trend as robust, additional participants join in, further propelling prices in that direction. This dynamic is exploited by momentum investors for potential gains.
What are the risks involved?
There are inherent risks in momentum investing, as with any other investment approach. Some of the potential risks associated with this strategy include:
- Reversals in the market: Since trends are not permanent, there is a constant risk that the market might change direction, resulting in potential losses for momentum investors. Momentum investors purchase stocks that have experienced recent price increases, anticipating the continuation of the upward trend. Nevertheless, it’s essential to recognise that past performance doesn’t guarantee future outcomes. Trends have the potential to reverse, and without caution, such reversals can result in substantial losses.
Momentum strategies are prone to herd mentality, where investors join in on purchasing a surging stock merely because others are doing so. This collective behaviour can drive prices to unsustainable heights, rendering them more exposed to a sudden and significant correction. Surprising news, economic data, or unforeseen events have the potential to prompt swift shifts in investor sentiment, leading even robust trends to reverse rapidly.
- Market volatility: Engaging in momentum investing can be characterised by fluctuations, given its frequent buying and selling of assets. This dynamic nature may induce stress among certain investors and result in increased transaction costs.
This is because momentum strategies frequently entail active trading, swiftly entering and exiting positions to seize short-term trends. Such practices can result in substantial fluctuations in portfolio value, causing stress for investors who favour a more stable investment journey.
By concentrating on recent price shifts, momentum investors become more vulnerable to market noise and temporary price fluctuations. This heightened sensitivity can increase volatility and pose challenges in adhering to a long-term investment strategy.
- Psychological factors: Momentum investors may be influenced by behavioural biases, including the tendency to pursue trending stocks or sell prematurely due to the fear of missing out on potential profits. Such unwarranted biases can exert a notable influence on momentum investing, possibly resulting in less-than-ideal outcomes. This entails purchasing stocks that have already experienced substantial price hikes, with the expectation of capitalising on the ongoing momentum. Such an approach may involve acquiring assets at inflated prices, heightening the risk of losses in the event of a trend reversal.
Utilising momentum investing can serve as a valuable strategy for investors aiming to leverage prevailing trends. However, it is essential to carefully assess both its benefits and possible drawbacks. In essence, this technique is typically viewed as a short-term strategy, aiming to seize rapid profits from prevailing trends. As opposed to many investors viewing this method as an easy way to earn from the market, investing based on market trends doesn’t assure automatic wealth accumulation, emphasising the necessity to conduct thorough research before committing any funds.
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First Published:
12 Feb 2024, 07:10 PM IST
Business NewsMoneyPersonal FinanceMomentum investing: What is it and what are the main risks involved in following this investment approach?
FAQs
This entails purchasing stocks that have already experienced substantial price hikes, with the expectation of capitalising on the ongoing momentum. Such an approach may involve acquiring assets at inflated prices, heightening the risk of losses in the event of a trend reversal.
What are the risks of momentum investing? ›
High Risk: Momentum investing is inherently risky. Very often, it relies on the continuation of trends. If the momentum reverses, it is likely to result in substantial losses, especially if the investor holds onto the position for too long.
What are the disadvantages of momentum funds? ›
Momentum funds are equity-oriented and prone to potentially high levels of volatility especially in the short-term. One needs to seek out potentially low volatility investments when selecting emergency funds, so momentum schemes are not suitable for this purpose.
Is it safe to invest in momentum funds? ›
Since momentum investing relies more on short-term price movements, it is considered to be very risky. This makes them suitable for the risk-aggressive investors.
What is the main risk of investing? ›
All investments carry some degree of risk. Stocks, bonds, mutual funds and exchange-traded funds can lose value—even their entire value—if market conditions sour. Even conservative, insured investments, such as certificates of deposit (CDs) issued by a bank or credit union, come with inflation risk.
What is meant by momentum investing? ›
Momentum investing is an investment strategy aimed at purchasing securities that have been showing an upward price trend or short-selling securities that have been showing a downward trend. The main rationale behind momentum investing is that once a trend is well-established, it likely to continue.
Is momentum a risk factor? ›
The momentum risk factor is designed to buy assets that performed well and sell assets that performed poorly over the past 3 to 12 months.
What are the pros and cons of momentum trading? ›
Momentum trading can offer the potential for significant profits by capitalizing on strong and persistent trends in asset prices. However, it also carries inherent risks, including the potential for significant losses if trends reverse abruptly or unexpected market events occur.
What are the advantages and disadvantages of momentum? ›
Advantage: Momentum strategies exploit persisting trends. Disadvantage: Momentum strategies struggle to adjust to rapid changes in market conditions. Advantages: Decreases momentum crashes and leads to higher risk-adjusted returns. Disadvantages: No enhanced momentum strategy emerges as consistently superior.
What is the difference between momentum investing and value investing? ›
Investment Style: Value investing focuses on undervalued stocks with strong fundamentals which have a potential in the long-term, whereas momentum investing focuses on stocks that have shown strong price performance, along with improving financials and is expected to continue in the trend in the short to medium term.
A momentum fund helps you identify stocks that show strong recent price trends. The price trend can be both positive and negative. In the case of positive momentum, a fund manager usually invests to make a profit. However, in the case of negative momentum stocks, the fund manager short-sells to make a profit.
What is the safest investment to invest in? ›
Here are the best low-risk investments in 2024:
- High-yield savings accounts.
- Money market funds.
- Short-term certificates of deposit.
- Series I savings bonds.
- Treasury bills, notes, bonds and TIPS.
- Corporate bonds.
- Dividend-paying stocks.
- Preferred stocks.
Although momentum is a short-term phenomenon, it is best suited for long-term investors. It won't always work, but there's a good chance that a disciplined momentum strategy will continue to outperform over the long term.
What is the biggest risk for investors? ›
1. Market risk. The risk of investments declining in value because of economic developments or other events that affect the entire market. The main types of market risk.
What are risks and hazards? ›
A Hazard is something that has the potential to harm you. Risk is the likelihood of a hazard causing harm.
What is downside risk in investing? ›
Downside risk is an estimation of a security's potential loss in value if market conditions precipitate a decline in that security's price. Depending on the measure used, downside risk explains a worst-case scenario for an investment and indicates how much the investor stands to lose.
Why is momentum trading difficult? ›
Risk management in momentum trading
Market volatility: High volatility can lead to erratic price movements, making it difficult to accurately identify genuine momentum trends. Overbought and oversold conditions: Relying solely on momentum oscillators can result in false signals, especially in strongly trending markets.
Which is considered the riskiest investment strategy? ›
The riskiest investments are often speculative in nature. While there are investment opportunities in each asset class that could result in you losing some or all of your money, cryptocurrency is often considered to be among the riskiest types of investments.
What are the disadvantages of activist investing? ›
Disadvantages of Individual Activist Investors
For example, an activist shareholder may only prefer a short-term holding time horizon;. They will influence management to make decisions that benefit the company in the short term to the detriment of shareholders with a long-term holding time horizon.
Does momentum investing work in the bear market? ›
While momentum investing may not be suitable for everyone, it offers several advantages that can be particularly beneficial during bear markets. 1. Potential for Outperformance: Momentum funds have the potential to outperform other investment strategies during bear markets.
