What Is Momentum Investing? Should You Use This Strategy While Selecting Stocks?

In the last 6 months, the Indian markets saw a very sharp fall and an equally fast recovery that astonished everyone. Since the fall of March 2020, Sensex has given an absolute return of 51%. But one index has performed better than the Sensex in this pandemic and historically as well. This index is the S&P BSE Momentum Index. Here’s a snapshot of the performance of these two indices:

Clearly, Momentum strategy has outperformed Sensex with a very wide margin in the past. Consistently over the last 5 years, this index has outperformed Sensex even during extreme volatility. So, what is Momentum Strategy? And should you use it while selecting stocks for investments? Let’s deep dive into this and understand in detail.

What Is Momentum Investing?

With a history of more than 200 years, Momentum Investing Strategy still works across various markets. In simple words, Momentum investing is buying stocks that are going up. Because as the trend goes, rising stocks keep going up for a certain time frame and falling stocks keep falling for a certain time frame. This is the exact opposite of Value Investing, where you buy undervalued stocks and wait for them to start going up.

While logically, this may sound like the failed approach because why would anyone want to buy an overpriced stock in hopes that it will go up even more. However, as we saw in the chart above, Momentum Investing definitely works.

Two Types Of Momentum Strategies Are Important To Know About:

1. Relative Momentum: In this strategy, before investing, investors compare the performance of stocks to each other. And, they shortlist the stocks which have outperformed compared to others in the recent past. Investors will invest in these stocks hoping that they will give similar returns over the next few months.
2. Absolute Momentum: In this strategy, Investors will compare the performance of a stock to its own historical performance. If they find a stock with positive performing stocks then they invest into it. And they avoid negative performing stock.

However, this entire strategy goes against the age-old stock investment wisdom of “Buy Low and Sell High.” One thing that is clear from this strategy is it is a High-Risk High Reward strategy that works over shorter time frames. So, what are the risks involved in Momentum Investing?

Risks In Momentum Investing

One of the most natural risks of this approach is the drawdown risk. When an investor is selecting stocks that have already gone up, there is a significant risk that it will go down and the investor will end up in significant losses.

Another factor to not in risk is the high turnover of the portfolio. It is clear that this strategy needs high churning in the portfolio because a particular stock may only go up for some months and will eventually start coming down. Hence, it is important to time entry and exit right and keeps churning the portfolio by identifying new investment opportunities.

Not understanding the trend reversal can lead to huge losses in this strategy. Right Implementation of the Momentum strategy is crucial for it to work in your favor. If you invest in a stock that is on the cusp of reversal can translate into heavy losses in the portfolio.

Should You Use Momentum Investing While Investing In Stocks?

Only investors with high risk appetite should consider momentum investing strategy while creating a stock portfolio. While back testing of this strategy looks good, there can be times when this will undergo significant volatility. It is also essential to get timing right while using this strategy. Hence, our recommendation before going for this strategy is twofold.

The first thing to do is combine Momentum investing with fundamental analysis. While you shortlist, the stocks based on past performance, also look at their fundamentals and ensure that the stock is of high quality. By doing this, even if the stock price goes down for the short term, eventually it will come back up considering the strong fundamentals.

Limit the exposure to such stocks to 15-20% of the entire portfolio. A lot of professionals also struggle to implement momentum strategy successfully. Hence, it is ideal to limit the exposure to these stocks so that in case of a loss due to this strategy, it will be contained and will not have a big impact on the portfolio.

Remember, every strategy works until it stops working. As a retail investor, a better approach is to create a portfolio with a mix of all strategies so that at the end you benefit from it.