Momentum investing is an investment strategy where financial assets like stocks, indexes, derivatives, bonds, or commodities that are displaying strength are assumed to continue rising at least in the near term, therefore we purchase such securities while selling those that are exhibiting poor returns. As a result, a portfolio of such assets is expected to provide higher returns than the whole market. Let's get into the nitty-gritty here.
The Intricacies of Momentum Investing
There's nothing new about this approach to investing. Methods for this technique are based on a financial principle known as "reducing one's losses and riding one's winnings." As a result of the notion of momentum investment, past short-term performance is replicated, with the successful continuing to be successful and unsuccessful companies continuing to be ineffective.
Whenever the price action momentum is strong, this strategy is solely dependent on price action data. When the price moves up or down across a large range in a short period of time, the market has high momentum.
Causation of Momentum Investing
There is evidence that investors typically over-or underreact to news, resulting in price movements and, ultimately, inefficiencies in the financial system. The timing of the market might also be a factor.
In the case of a stock, for example, investors may be reluctant to respond to fresh information about the company, but suddenly realize the significance and move quickly, resulting in momentum. Momentum like this usually lasts just a few months, usually between six and twelve months.
Types of Momentum Investing Strategies
Time-series or absolute momentum and cross-sectional momentum are two kinds of momentum investment techniques. Using time-series momentum, an asset's current performance is compared to its past performance. Shares may be ranked according to their 12-month performance, for example, to see which have performed better.
Time-series momentum may be determined using a specified profit percentage threshold, and typically, those shares/assets that have above the threshold are purchased. Comparing a particular asset's performance to that of other similar assets is what we mean by relative momentum. Over the course of a year, gold gained 15%, but stock gained just 12%. To put it another way, gold has a greater rate of change than stocks.
Advantages that Make Momentum Investing Strategies Viable
Investors may benefit from momentum methods. With the right data screen in place to detect momentum opportunities, and severe discipline applied to trade the method, investment outperformance may be achieved. Using market volatility to the investor's advantage is another advantage of momentum investing.
Following or avoiding turbulent market trends allows the investor to take advantage of the market's upward or downward movement. A diversified portfolio of time-series momentum strategies across all asset classes has been demonstrated to produce extra risk-adjusted returns with limited exposure to typical asset pricing variables that may perform well in severe market circumstances.
Investors may take advantage of other market participants' behavioural biases by using this method. The investor may reap the benefits of a methodical approach that recognizes when the market is chasing performance up or down. Identifying "herd mentality" based actions in the market is a great way for momentum investors to take advantage of emotional biases.
A few of these bad habits include: hanging on to losing stocks for much longer than necessary, selling stock too soon while it is gaining, and the general inclination of the market to put an excessive focus on current economic developments. Applying these strategies may help momentum investors capitalize on market sentiment and the resulting price movements.
The Return Potential of Momentum Investing
The issue inevitably arises as to whether momentum investing's excess returns will continue in the future, given the history and performance of this technique. A rise in the popularity of momentum methods does not always entail that the potential excess profits will be diminished by overcrowding. The technique seems to be lucrative in the long run.
There is no way to eliminate the behavioural biases outlined that may cause the momentum premium since human nature hasn't progressed far enough to do so. That momentum investing is frequently driven by chronic underreaction to good fundamentals remains true.
Momentum investing's returns are expected to continue to grow in magnitude and consistency over time, allowing investors to sustain profitability and overcome related expenditures, according to a recent study.
Research released in 2014 also shown that momentum strategies contribute to outperformance on both the short and long sides and may work effectively with both big and small capitalization equities.
The inherent risks of implementing a momentum investing strategy should be understood by investors. Investing in an asset class based only on the actions of other market players falls under this category. There's no way to know whether this kind of purchase will keep the price from rising.
According to empirical data and back-testing methodologies, momentum trading strategies are successful. However, investors should bear in mind the above-mentioned points when utilizing these strategies.