By Arjun Chandrasekar.
Momentum investing, in simple terms, is investing in a stock based on its past performance and trend growth. It’s generally a long-term investment, and it banks on the notion that the stock will continue its upward trend. Investors analyze a stock’s historical trend — from anywhere between 3 to 12 months — and make an assumption on whether it is safe to invest in or not. On the flip side, if the stock has had negative returns for the same period of time, then investors will sell, or hedge their bets on it losing value. This strategy relies on basic analytical and number-crunching skills just by looking at a stock’s past trends, investors can easily notice if a stock will continue to rise or fall. If a stock has had a long history of negative returns, the sensible thing to do is to not invest in it, and if a stock has displayed consecutive months of high returns, then investors are more likely to invest in it. After years of research into momentum investing, experts have come to the conclusion that this strategy receives average returns of at least 1% per month for the entire duration of an investment.
“Buy low and sell high” is one of the most common sayings in the investing world, and it is the origin of momentum investing. Richard Driehaus, a famous American businessman, theorized the idea of momentum investing. He was the founder and CIO at Driehaus Capital Management LLC until his unfortunate death on March 9th, 2021. Nonetheless, he will always be remembered for his exceptional knowledge of business and his contributions to investing.
Pros and Cons
As with all investment strategies, momentum investing comes with pros and cons. Let’s review some of them.
- Seasonal indicators: Using this strategy can be beneficial as it typically follows a seasonal trend. If a stock has done poorly for the past couple of months, at the end of the year investors are likely to sell so they don’t have to pay taxes. “At year end, taxable investors would rather jump off a bridge than realize a large capital gain in November or December.” (alphaarchitect.com). Investors are much more likely to hold on to high-momentum stocks and sell low-momentum stocks at the end of the year to avoid high taxes and increase overall momentum.
- No general basis: This strategy can be labeled as a bandwagon type, where investors only look at hot stocks that everyone else is investing in. Rather than doing their own self-analysis using realistic data, they just search up the trends and buy into them at the wrong time.
Overall, momentum investing is a great strategy for beginner investors, as it doesn’t require statistical research or analysis on your end. However, if anything, we advise you to briefly review the stock’s past trends to see if it has risen or fallen, review the latest trends, and then make your decision. Technical analysis can be very powerful when doing momentum investing, not only because you’ll understand the past trends of the stock, but you’ll also be able to recognize whether it’s undervalued or overvalued, which can help in deciding whether it will have high returns in the months ahead.
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