What Are Momentum Investors and How Do They Invest?

Investment strategies offer various approaches for individuals seeking to grow their wealth. Momentum investing is a distinct strategy that centers on the idea that assets performing well in the recent past will continue to do so, and similarly, those performing poorly will likely continue their downward trend. This approach involves identifying and capitalizing on the persistence of existing market trends. It stands apart from strategies that focus on intrinsic value or long-term fundamental analysis, instead emphasizing price and volume movements.

Defining Momentum Investing

Momentum investing is an investment strategy where investors aim to profit from the continuation of existing price trends in financial markets. The fundamental concept is that assets with strong recent performance tend to maintain that upward trajectory, while those that have performed poorly often continue to decline. This persistence of trends forms the bedrock of the momentum strategy. Once a trend is established, it tends to endure for a measurable period, applying to individual stocks, sectors, or broader market indices. Momentum investors are not concerned with whether an asset is undervalued or overvalued, focusing instead on the direction and strength of its price movement.

Investors employing this strategy “go with the flow” of the market, riding assets already moving upwards and avoiding or shorting those moving downwards. This approach contrasts sharply with value investing, which seeks assets trading below their perceived intrinsic worth. Momentum investing operates on the belief that market prices reflect persistent human behaviors and structural market inefficiencies. Market trends often exhibit a degree of inertia, allowing investors to enter positions after a trend has begun and exit before it fully reverses. This dynamic approach requires continuous monitoring of market data.

Core Principles of Momentum Investing

The underlying philosophy of momentum investing is rooted in trend following. This principle suggests that once a price trend is in motion, it is more likely to continue than to reverse in the short to medium term. Investors using this approach identify these established trends and align their portfolios accordingly, believing that markets often under-react to new information, causing trends to unfold gradually.

Another core tenet is relative strength, which involves comparing the performance of one asset against another or a benchmark. Assets exhibiting superior performance relative to their peers or the broader market are considered to have strong momentum. This comparative analysis helps investors pinpoint the strongest performers within a given universe of assets. The goal is to allocate capital to those assets demonstrating the most robust upward price movement.

The strategy can be summarized by the adage “buy high, sell higher.” Momentum investors purchase assets that have already appreciated significantly, expecting further gains. Conversely, for assets in a downtrend, the principle becomes “sell low, buy lower” or “short low, cover lower,” aiming to profit from continued declines. This approach stands in contrast to conventional wisdom that often advises buying assets when they are cheap.

Behavioral finance provides insights into why momentum might persist. Investor herding, where market participants mimic others, can contribute to trend continuation. Additionally, under-reaction to new information, where market prices adjust slowly to fundamental news, can create opportunities. These psychological factors can lead to prolonged periods of price movement in a single direction.

Identifying Momentum

Identifying momentum involves analyzing market data points to determine the strength and direction of an asset’s price trend. One common metric is to examine an asset’s total return over specific look-back periods, such as 3-month, 6-month, or 12-month periods. For example, a stock significantly outperforming the market over the past 12 months might possess strong momentum.

Moving averages are another widely used tool for identifying trends. A moving average smooths out price data, making the underlying trend easier to see. Common moving averages include the 50-day and 200-day simple moving averages. When an asset’s price crosses above its moving average, it can signal an uptrend, while crossing below can indicate a downtrend.

The relationship between different moving averages also provides momentum signals. A “golden cross” occurs when a shorter-term moving average, like the 50-day, crosses above a longer-term moving average, like the 200-day. This event is often interpreted as a bullish signal, indicating strengthening upward momentum. Conversely, a “death cross,” where the shorter-term average crosses below the longer-term one, can signal a bearish shift.

Volume analysis also confirms momentum. Strong price trends are often accompanied by higher trading volume, indicating strong conviction among buyers or sellers. An increasing price on high volume suggests robust buying interest, supporting upward momentum. Conversely, a declining price on high volume indicates strong selling pressure. Analyzing volume alongside price movements helps confirm the validity and strength of a trend.

Implementing a Momentum Strategy

Constructing a portfolio based on momentum typically begins with a defined universe of assets, such as a large-cap stock index or a specific sector. From this universe, investors select a predetermined percentage of assets exhibiting the strongest momentum, perhaps the top 10% or 20% based on their chosen metrics. This selection process ensures that capital is allocated to the most vigorously trending assets at a given time.

Entry and exit points are governed by specific signals derived from momentum indicators. For example, an investor might initiate a position when an asset’s price crosses above its 50-day moving average and its 12-month return is positive. Conversely, a position might be closed if the asset’s price falls below a key support level or if its momentum rank significantly declines. These predefined rules help remove emotional bias from trading decisions.

Position sizing is a consideration in managing risk within a momentum portfolio. Investors typically allocate a small, fixed percentage of their total capital to each individual position, often ranging from 1% to 5%. This approach helps limit potential losses from any single asset that might reverse its trend unexpectedly. Diversification across multiple momentum-driven assets also helps mitigate specific asset risk.

Ongoing monitoring and regular rebalancing are essential for a momentum strategy to remain effective. Market trends can shift rapidly, necessitating frequent adjustments to the portfolio. Investors commonly review and rebalance their holdings monthly or quarterly, selling assets that have lost momentum and acquiring new ones that have gained strength. This disciplined rebalancing ensures the portfolio consistently holds the strongest trending assets.