Momentum investing is a method of buying securities or stocks based on its returns during the last three to twelve months. This method also insists that it is wise to sell the stocks which have had poor returns or profit during the same time frame. Momentum investors will invest in anything which is currently hot, like purchase a stock that has high returns, invest on precious metals, bonds, mutual funds or currencies.
Momentum investors generally look for three things in a company:
- A strong price chart
- Quick earnings increase
- Recent positive changes in earnings growth
Types of momentum
Momentum investing can be further divided into two types.
- Relative Strength (Momentum of price): It is a tool used to gauge performance. Relative strength measures how a stock has performed compared to the overall market over a specific period of time.
- Earnings Momentum: The earnings momentum is increasing earnings per share, which begins with strong quarterly year over year earnings increase.
Momentum investors keep all their money invested in only the current top performers, those who have outperformed in the market during the last twelve months. Their prime goal is to always be in most popular and fastest growing investments.
Momentum investors also consider that the market is too complex to predict which assets or companies will perform well long-term. Hence, they invest money randomly in the market that becomes popular by choosing an asset or a company which has been recently doing well.
Due to various assumptions made in this method of investing, momentum investors need a system that identifies today’s best investments, and they also need a system to warn them to move out of investment when the performance starts to go down.
Momentum investing is an exhaustive research and time sensitive strategy. Most of the research includes “Technical Analysis” and “Statistical Analysis” that identifies which investments currently offer the best chance for quick growth. However they do not forecast when market cycles start or end.
Statistical Measures used by Momentum investors
The statistical measures used by momentum investors to analyze market and investments are:
Standard Deviation: Standard Deviation gauges how much an investment diverges from its average.
Beta: Beta gauges investment volatility against a benchmark.
Alpha: Alpha compares an investment’s expected performance. The comparison is done based on its beta to its real performance. You can see a negative alpha if an investment underperforms expectations.
Sharpe Ratio: Sharpe Ration is a relative measure, which helps momentum investors to exactly compare the risk and performance of totally different types of assets to each other. This uses standard deviation to compare an investment’s risk and returns.
Momentum investors also integrate charting and technical analysis to identify investments that are entering a strong growth cycle. It also warns when the cycle will end, which helps in setting buying and selling limits.
Momentum investing is not a strategy for traditional or timid investors; your collection of positions will always be unpredictable and will require constant attention. A major risk associated with a momentum investment strategy is buying stocks when the market is shifting directions, which can result in large losses. Momentum investors get into risk if they are not good at statistical and technical analysis.
Benefits of Momentum investment
A solid momentum investment strategy gives you quick profit compared to long term buy and hold strategies. Though momentum investing strategies have significant risks, the possibility of high returns can sometimes compensate for the risks involved.