What is Momentum Investing and How Can Investors Benefit?

Momentum investing can be defined as an investment strategy that focuses on the approach of “buy high and sell higher”. Momentum investors typically attempt to choose investments that can help them grow their wealth by riding the growth wave of a specific stock or group of equity stocks. This can help investors benefit from the upward momentum of markets and potentially post substantial returns in the future.

Momentum investing strategies are often not limited to long-term investments and may involve investing in basket of equity stocks, exchange traded funds (ETFs), mutual funds, commodities and even futures and options (F&O) contracts. One should keep in mind that while momentum investing can be potentially profitable if one learns to track an underlying trend in the market, it does involve common risks associated with making equity investments.

The primary aim of a momentum investor is to buy high and sell higher. Sounds confusing, isn’t it? Let’s break it down into simpler words.

The idea is to identify a sector or even a single equity stock that has recently witnessed growth and is anticipated to witness further growth momentum in the medium to long term. From the list of qualifying momentum stocks, prospective investors would also have to narrow down their options by looking for sector-specific stocks that have the potential to showcase maximum strength in momentum. Usually, momentum investors look for stocks that have had high returns in the past 3-12 months.

After picking out stocks that have generated higher returns compared to their peers and benchmark in the recent past, momentum investors invest in such stocks or basket of stocks. This is done with the anticipation that the market prices of these investments will continue to increase in the near future.

However, one of the most important aspects of momentum investing in contrast to a typical long-term investment strategy, is selling off the investments when the peak value is reached. After benefiting from the short-term uptrends, the investor has to sell the investments before they start losing their upward momentum. So, investors have to time the market correctly to achieve the key goal of momentum investing. As a result, many experts do not consider this investment strategy suitable for many investor groups.

Now that you have a better understanding of the basics of momentum investing, you might have realized that the successful implementation would require 2 key aspects. It is firstly crucial to have a clear understanding of how financial markets work and secondly the ability to correctly anticipate future market movements. This can be a tall order for many investors. There is however a way in which even novice investors can benefit from momentum stocks – by investing in a momentum fund.

A momentum fund is an equity scheme where a professional fund manager with the help of a team of analysts decides which momentum stocks to invest in to create a portfolio of such stocks. The primary aim of a momentum fund is to invest in stocks of companies that are already riding the wave of success, benefit from further rise in the price of these shares, and then exit once the trend reaches its peak. While even the best fund manager might not be able to time markets correctly every time, their market insight does improve the odds of success compared a novice investor investing in momentum stocks.

In some ways, the basic ideology of momentum funds is contrary to those of a value fund. Simply put momentum strategy involves investing in stocks that have witnessed robust growth already, with the aim to exit the investment when the stock price reaches even higher levels irrespective of the time elapsed between the time of investment and reaching the peak. On the other hand, value investing involves investing in stocks that are currently undervalued and available at a lower cost as compared to their intrinsic value, but can end up giving high return in the medium to long term.

Discussed below are some notable ways you can benefit from momentum investing:

• High Potential Returns: Historically, momentum investment strategy has offered high returns to investors when compared to other investment strategies and key benchmark indices. This is primarily because when chosen correctly, momentum stocks give higher future returns even though the investment is made at a high level already. So, the returns can be significantly high if the market is timed right.
• Exposure to Secular Market Trends: A secular market trend refers to a market movement that is not specific to a single sector or market cap. Momentum investing involves finding these hidden trends in the market and capitalising on them before they reach their peak. This investment strategy, thus, allows you to benefit from price trends across various sectors and markets.
• Benefits of Market Volatility: Market volatility is a key feature of equity investing Understanding market volatility and using it to one’s benefit is one of the significant advantages of momentum investing. If a momentum investor comes across a downtrend, he/she may decide to hold and wait for positive momentum to gain control. On the other hand, an uptrend presents itself as the perfect opportunity to get potentially significant returns.
• Diversification of Investments: Momentum trends often involve multiple sectors and equity stocks. This can help investors diversify their equity investments across multiple companies and industries. As a result, momentum investors can benefit from the potentially lower risk and optimal returns generated from a diversified investment portfolio.

Now, let’s discuss some key limitations of momentum investing:

• Needs Constant Research: This investment strategy is highly time-intensive; you need to keep track of the price of a specific stock or a basket of stocks on a daily basis to choose a suitable investment plans and reduce the risk of potential losses. This strategy requires an investor to execute both fundamental and technical analysis of a sector or a stock including their historical performance.
• Sensitive to Sudden Market Fluctuations: Momentum investing tries to benefit from price increase of a security. This indicates that this strategy works best in a bullish market. A bearish market or long-term downtrends can minimise the potential profitability of this strategy significantly.
• Necessity to Time Markets: Timing markets is essential in order to implement the buy high-sell higher philosophy that is at the care of momentum investing. But it might be challenging for any investor to time markets correctly every time. As a result, the potential risks involved when implementing this investment strategy can be significantly high especially for a novice investor.

So, who should follow the momentum investment strategy or invest in momentum mutual funds?

If you are someone who is willing to take potentially high risks and have an inherent understanding of the trends in the market, you can consider trying out momentum investing. In order to successfully benefit from this strategy, one needs to monitor the market closely and rebalance the portfolio whenever required.

Alternately, investors can also invest in momentum funds or index funds based on momentum indices that are managed by expert fund managers and market analysts. Professional fund managers and market analysts have an in-depth understanding of the underlying trends in the market and, hence, are better placed to benefit from a momentum investment strategy. However, it is still advisable to ensure that such schemes only form a relatively smaller part of the overall investment portfolio.