In some ways, rising stock prices are kind of a bad thing for investors. Rising stock prices means that a commodity is hot, which means more and more people will start to jump on the trend, eventually causing the securities to become overvalued.
After all, if everyone knew the secret to making it big in investing, then the strategy could not work for everyone.
Momentum investing, as the name would imply, involves capitalizing on a continuing market trend.
Momentum investing is seen by many as the “standard” or “default” investment option, as it seems to follow the rules of common sense; if something is rising in value, you try to hop on the train early to get the most out of it.
Like a ball pushed down a hill, once a stock starts to grow, its momentum carries it forward as the growth gets faster.
The idea behind momentum investing is that you can profit from market trends no matter how long those trends may be. Momentum investing can be seen as the converse of contrarian investing (read all about that here), an investment strategy based on going against the mainstream investor sentiment.
Whereas contrarian investors try to fight the current, momentum investors go with and ride the current.
How Does Momentum Investing Work?
The pioneering academic text on momentum investing is a 1993 study by Narasimhan Jegadeesh and Sheridan Titman from UCLS published in the Journal of Finance.
Jegadeesh and Titman showed that the strategy of buying stock winners and selling losers produced higher average returns than the market as a whole over a 30 year period.
Further, Jegadeesh and Titman determined that stocks performance over a 3 to 13 month period was a good predictor of projected performance for the next 3 to 12 months.
While their main thesis sounds like common sense, that growing companies are good investment decisions, Jagadeesh and Titman offered one of the first comprehensive studies and economic models with mountains of quantitative data backing up their hypothesis.
For example, the duo determined that portfolios selected based on a 6-month return and then held for 6 months generated a 1% increase in extra returns that what would normally be expected. Over time, this gain can turn into a large payoff.
Although Jagadeesh and Titman showed that momentum investing is a strategy that can pay off, they did not provide and explanation for why momentum investing works.
This question is particularly important because momentum investing seems to be at odds with the ‘efficient market hypothesis;” the idea that current stock prices reflect all relevant information about a company at a given time.
The idea behind the efficient market hypothesis is that investors are rational and that stocks value is just whatever pricing the market dictates it has.
Momentum investing is interesting because it seems to be at odds with the efficient market hypothesis and seems to imply that momentum investing can be used to generate higher than average returns.
Momentum investing typically involves assessing companies based on several technical indicators that tell investors about the exit and entry points for stocks and other securities.
Unlike other investing strategies like value investing, momentum investing is primarily concerned with anticipating the behavior of other investors. Momentum investors seek to take advantage of human beings’ tendency to follow trends and operate according to a herd mentality. The main idea is that once trends in a market show up, they are likely to continue into the discernible future.
Read More: Contrarian Investing Strategies 101
Important Indicators for Momentum Investing
The following is a list of important technical indicators that momentum investors assess when buying and selling securities.
Trend lines are used to assess price movements in a stock market. For any company, their stock performance can often be modeled as a zig-zag line that alternates between highs and lows.
A trend line is a line drawn between two points on this graph. If the line slopes upwards, that indicates a growth trend and that investors should buy shares. If the line is sloping downwards, the growth trend is negative and investors should sell off securities.
The time frame over which trend lines are assessed differs from investor to investor. Some momentum investors assess trends over 50 day periods while others do so over 200 day periods. In general, if a positive trend line is observed over a longer period, that usually indicates that growth is more stable and that investing in that company is a good idea.
Average Directional Index (ADX)
The Average Directional Index (ADX) is a measure that determines both the existence and strength of a trend in the market. The ADX is an average of the expansion or contraction of a particular security over a given time. Like trend lines, the ADX attempts to gauge the momentum of growth for a particular security.
ADX values go from 0 to 100. An ADX score of lower than 25 usually is taken to signify a directionless market with no clear trends. Higher readings signify the existence of larger and stronger trends. The ADX measure can be cross-referenced with trend lines to determine if pricing matches up with contraction or expansion.
A moving average is a technique that creates a constantly updating moving price average by smoothing out graphs of price data. Whereas trend lines are used to assess trends over longer periods of time, moving averages are a way to assess trends over any time scale, short or long.
One can understand moving averages in terms of limits and calculus. By assessing trends over shorter and shorter periods of time, investors can determine if changes in the average prices are indicative of a true trend or just a result of random noise in the market.
Just like limits allow us to precisely determine the rate of change of a function at a single point in time, moving averages give a way to assess the changing average prices over a set of points in time. Rising trends are usually associated with a moving average that stays above a certain value while downtrends are associated with a moving average that falls below a specific value.
Relative Strength Index (RSI)
The Rising Strength Index is a measure that charts price changes and the speed of those changes. Like the ADX, RSI assigns price changes a value between 0 and 100.
By assessing the speed of price changes, investors can determine if a trend is emerging. Generally, an RSI of over 50 means a positive upward trend while an RSI lower than 50 indicates a general downward trend. An RSI over 7 could indicate overvaluing of a particular security, while an RSI lower than 30 may indicate undervaluing.
Debates on Momentum Investing
There is currently much academic debate over the merits of momentum investing.
As it currently stands, most professional investment firms do not use a form of momentum investing, instead opting to focus on fundamental factors and discounted cash flows.
Many professionals may be averse to consider momentum investing a legitimate strategy because it seems to contradict the efficient market hypothesis, a central idea in modern finance.
Many people feel that momentum really has nothing to do with the fundamental valuable aspect of a company and is merely based on the psychological preponderance for humans to extrapolate trends into the future.
Many people dislike momentum investing and instead opt for more “passive” forms of investing, such as dollar-cost averaging.
The main evidence for passive forms of investing is the long-observed trend that professional money managers have continually failed to beat the market.
If markets are efficient, then current stock prices give us all relevant information about a company, which means it is very hard to determine if certain companies are expected to outperform.
Also, actively managed momentum funds typically have a higher expense ratio than passive funds.
Critics of momentum investing sometimes also claim that momentum investing has no social merit in that, instead of investing in the value a company has, momentum investors seek to exploit inefficiencies in markets.
This is more of a normative criticism, and not necessarily a criticism of whether momentum investing actually works.
However active momentum investors reply that while markets, on the whole, might be efficient, there are small windows of time before new information is reflected in the pricing of stock, and investors can take advantage of inefficiencies at those points.
Many advocates of more active forms of investing criticize those who favor passive investing for downplaying the integral role that human intuition and gut feelings play in the stock market.
In recent years, momentum investing has found more and more vocal supporters.
For example, in 2017 the American Association of Individual Investors released a study claiming that momentum investing strategies beat the S&P 500 over a 5-year and 10-year period.
So as of now, the verdict on momentum investing is currently out, but there is a growing body of evidence demonstrating the potential merits of momentum investing.
If the efficient market hypothesis is true, the momentum investing seems to be a dead end. However, it is known that human beings are fundamentally irrational creatures.
Why should we expect their behavior in financial markets to be perfectly rational?
If irrationality is more present in markets than orthodox economists would deign to admit, the idea momentum investing as a legitimate investing strategy receives a lot more support.