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What is… Momentum Investing?

Published on 19/11/2020

From early days sat in front of the TV watching Trading Places at Christmas, we’ve grown up with the age old adage “buy-low, sell-high”. And that might work for some, but for others, Trading Places is too 80s. “It’s 2020!” they cry, “it’s time for Momentum Investing!”

But what is it? Well, momentum investing is a strategy of buying stocks that have had high returns over the past three to twelve months, and selling those that have had poor returns over the same period. Where buy-low, sell-high is investing in companies that look cheap, and selling them if and when they get expensive, momentum investing is the opposite.

Momentum investors don’t value a company on the fundamentals - they don’t look at a company’s profits, losses, assets. Instead, they base their decisions on observations of stock market trends; they buy stocks that are going up, and sell or avoid those that are going down.

To see which trend is worth hopping on, momentum investors use technical analysis. This involves looking at charts of share prices and using various pattern-spotting methods to find potential entry and exit points, as well as gauging the strength of the trend. The goal is to work with volatility by finding opportunities in short-term uptrends and then sell when they start to lose momentum.

Technical analysis is also used to analyse, understand, and predict the behaviour of other investors in the market. Even the most experienced investor can have biases and let emotions cloud their judgement, so momentum investors are keyed into this.

On the whole, investing biases fall into two main categories: emotional and cognitive. Emotional biases are spontaneous, and are based on the personal feelings of an individual at the time a decision is made. This could be related to a personal experience, or based just on a feeling they have. Cognitive biases involve decision making based on established concepts that may or may not be accurate - decisions are made based on a subjective reality.

Momentum investing is somewhat academically inconvenient, as it contradicts the market efficiency hypothesis. This widely held hypothesis states that asset prices reflect all available information. In theory, shrewd investors shouldn’t buy a stock just to get on the bandwagon - they shouldn’t react to prices emotionally… but sometimes they do! When a share price rises, investors’ fear of missing out on a trend can often attract a growing stream of buyers, and conversely a growing stream of sellers if a share price drops, even if there is no new information available on a company.

There have been several studies on momentum investing because of its academic inconvenience, and they have shown that it works! Because of this, momentum investing has been described as an investing anomaly. A potentially profitable, well regarded and highly adopted anomaly.

As with any kind of investing, momentum investing has its risks. No one makes money on everything all the time. But momentum investing involves extra dedication and patience, understanding market trends, investor biases and deep knowledge of stock markets - not to be tried by a fresh faced first-timer! But this shouldn’t put you off, as with everything, research and revision is the key.

Every great investor and scientist does their research, and as we say here at Upside, there’s a science to being right.

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