All you need to know about momentum investing

Momentum investing is based on the principle that securities that have exhibited strong performance recently are likely to continue performing well in the near future, and the stocks that have performed poorly are likely to continue underperforming. In line with this, momentum mutual funds aim to capitalise on the momentum exhibited by certain stocks or securities in the financial markets. A majority of the momentum mutual funds in India are momentum index funds, which follow a passive investment strategy that aims to replicate the performance of a stock market index, subject to tracking error.

Momentum funds invest in high-performing stocks experiencing an upward trend in the market, eventually selling them off after they reach their peak.

• Table of contents

1. What is Momentum Investing
2. Key strategies in momentum investing
3. How is Momentum Calculated?
4. What are the Risks Involved in Momentum Investing?

What is Momentum Investing?

Momentum investing is a strategy that involves buying stocks that have been showing an upward price trend. As the name suggests, the idea is to potentially leverage the upward momentum of these stocks. The belief behind this strategy is that stocks that have been performing well in the recent past in the past will continue to do so in the near future. When the price of the security seems to have peaked and the decline begins, the stock is sold off.
Momentum investing has the potential to yield significant returns in a short period. However, it also carries substantial risks, as market trends can reverse quickly and unexpectedly. This strategy thus requires a keen understanding of market dynamics and may be suitable for experienced investors who can closely monitor market movements and are comfortable with the volatility and risks associated with this strategy.

Key Strategies in Momentum Investing

Now that you know the momentum investment meaning, here are a few things you must understand about momentum investment strategies:

• Price momentum: It focuses on analysing the recent price movements of securities to identify those with strong positive or negative momentum. Securities that have experienced significant price appreciation over a specified period are considered to have positive momentum, while those with significant price declines are considered to have negative momentum. Securities with a positive momentum are selected for investment.
• Near-term focus: Momentum investors aim to capture short-term price movements and potentially capitalise on trends as they unfold in the market.
• Relative strength: Momentum investment involves comparing the performance of individual securities relative to a benchmark or other securities within the same asset class to identify securities that have outperformed their peers or the broader market over a specific time frame.

How is Momentum Calculated?

There are different metrics to calculate momentum, but some elements in these calculations include:

• Time frame: Momentum has to be calculated over a time frame – for instance, a few days or a few months.
• Price indicator: Price indicators are formulae that use past prices and trading volumes of stocks to help predict where their prices might go next.
• Calculate returns: Returns are calculated by comparing the price of the security at the beginning of the time period being considered and at the end of this period.

What are the Risks Involved in Momentum Investing?

Momentum investing entails all the general risks involved in stock market investing, as well as some specific risks related to this strategy. These include:

• Market reversals: Sudden changes in market trends can lead to significant losses. Stocks that have been performing well might experience abrupt declines, catching momentum investors off-guard.
• High volatility: Momentum stocks often exhibit high volatility, which can result in large price swings. This volatility increases the risk of substantial losses if the market moves against the investor's position.
• Overtrading: Momentum investing typically involves frequent buying and selling, leading to higher transaction costs and potential tax liabilities. These costs can erode overall returns.
• Liquidity risk: Some momentum stocks may have low liquidity, making it difficult to enter or exit positions without significantly impacting the stock's price.
• Behavioural bias: Momentum investing decisions can be influenced by biases such as herd mentality, which can drive up prices and lead to steep falls. Other biases such as fear, greed, loss-aversion and more can also lead to irrational decisions based on emotions rather than analysis.

Conclusion

Momentum investing seeks to capture short-term price trends in financial markets. While momentum mutual funds have the potential to generate capital appreciation over time, they carry a relatively high level of risk. Investors who want to invest in momentum index funds or mutual funds should carefully assess their risk tolerance, investment objectives, and time horizon. An SIP calculator online can help investors simulate different SIP investment scenarios in momentum funds, allowing them to gauge the potential returns and risks based on their contributions and investment duration. By inputting variables like risk tolerance and expected returns, investors can make more informed decisions about how to align their SIP strategy with their financial goals and market conditions.

FAQs

Who should invest in momentum mutual funds?

Investors who have a high risk tolerance and medium-to-long investment horizon can consider funds following momentum investment.

Momentum fund or value fund, which is better?

Both types of mutual funds are suitable for different types of investors. Momentum funds seek to potentially capitalise on the continuation of recent price trends, while value funds invest in undervalued stocks that have the potential to perform well in the future. Both entail risks, but momentum stocks may be more volatile in the short term. It is important to note that past performance may not be sustained in the future, which increases the risk factor in momentum investing.

How long should I hold my momentum fund investment?

The optimal holding period for a momentum fund investment depends on various factors, including market conditions, risk management considerations, and the scheme’s investment objectives.

Mutual Fund investments are subject to market risks, read all scheme related documents carefully.
This document should not be treated as endorsement of the views/opinions or as investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document is for information purpose only and should not be construed as a promise on minimum returns or safeguard of capital. This document alone is not sufficient and should not be used for the development or implementation of an investment strategy. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision. Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals and horizon. This information is subject to change without any prior notice.