Momentum Investing

In the stock market, some companies see their share prices rise for a long time, while others experience a steady decline. So is it better to buy shares of a company whose stock has already gone up significantly? Or is it better to buy shares of a company whose stock has fallen and now looks cheap? Many people see a falling stock price as an opportunity to buy at a discount. Momentum investors, however, see things a little differently. They focus on the possibility that stocks that have already been rising may continue to rise. This approach is called momentum investing. The word "momentum" originally comes from physics, where it describes the motion of an object. In investing, the idea is similar to that of an object continuing in motion. If a stock price has been rising, that upward trend may continue for some time. Likewise, if a stock has been falling, its downward trend may continue. Imagine that six months ago, shares of Company A and Company B both traded at $100. Today, Company A's stock has risen to $140, while Company B's stock has fallen to $90. Company A has gained 40%, while Company B has lost 10%. Some investors might see Company B as the better opportunity because its shares have become cheaper. A momentum investor, however, might be more interested in Company A. The reason is that Company A has demonstrated strong upward momentum over the past six months, which could continue into the future. But why would a stock that has already risen significantly keep going up? One reason is that it can take time for new information about a company to be fully reflected in its stock price. Imagine that a company develops a new technology or reports earnings that are better than expected. At first, only some investors may recognize the significance of the news. As more investors become convinced of the company's growth potential and begin buying its shares, the stock price may continue rising over several months. Another reason involves human psychology. People tend to pay attention to things that have performed well recently. When a stock keeps rising, more investors may become interested in it. Their purchases can push the price higher, and that higher price may attract even more investors. However, this behavior is not always driven by rational decisions. Sometimes, investors push a stock's price far above what the company is actually worth. This is why it is important to consider whether a stock's rising price reflects genuine business growth or simply investor excitement and expectations. There are two main approaches to momentum investing: relative momentum and absolute momentum. Relative momentum involves comparing several investments and selecting those that have performed better than the others. For example, an investor might compare the stock returns of 10 companies over the past six months and choose those with the strongest gains. The focus is not on how expensive a stock is, but on how strongly it has performed compared with other stocks. Absolute momentum, on the other hand, looks at whether a particular investment has risen or fallen over a certain period. For example, an investor might create a rule to invest in a stock only when its return over the past six months is positive and avoid it when that return is negative. While relative momentum compares investments with one another, absolute momentum evaluates each investment based on its own price movement. Momentum investors often examine stock performance over periods such as three, six, or twelve months. However, there is no single time frame that everyone must use. The results of a strategy can vary significantly depending on the period selected. More importantly, a stock's recent rise does not guarantee that it will continue rising. In fact, momentum investing can become especially risky when a stock that has been rising for a long time suddenly falls sharply. Imagine buying a stock at $150 after watching it climb from $100 to $150. If its price then drops to $90, you would lose 40% of your investment. The fact that the stock previously gained 50% does nothing to protect someone who bought it later. Momentum strategies can also suffer significant losses when market conditions change suddenly. Stocks that were previously popular may fall sharply, while stocks that had been declining may rebound quickly. This kind of rapid reversal can sometimes lead to what investors call a momentum crash, when established momentum trends break down. Frequent trading is another concern. Momentum investors may periodically compare stock performance and replace some of their holdings. Each time they buy or sell, they may incur trading costs and, depending on the circumstances, taxes. If they trade too frequently, these expenses can reduce the amount of money they actually keep, even when their investments make a profit. So how does momentum investing differ from investing based on a company's value? Investors who analyze a company's value examine factors such as how much profit it earns, how much it might grow in the future, and whether its current stock price is reasonable compared with the value of the business. Momentum investors, by contrast, pay more attention to the direction in which the stock price has been moving. Of course, these two approaches do not have to be used separately. An investor can study a company's financial performance and growth potential while also considering its stock price trends. For example, someone might look for companies with healthy finances and growing profits whose shares have also shown strong recent momentum. However, a rising stock price does not automatically mean that a company is a good business. Likewise, a falling stock price does not necessarily mean that a company is a bad business. Stock prices are influenced by many factors, including corporate earnings, interest rates, economic conditions, and investor expectations. If you want to understand momentum investing, you can practice using historical stock prices before investing real money. Try comparing the six-month returns of several companies, selecting a few based on their momentum, and then examining how their stock prices performed afterward. When doing this, it is important to account for trading costs and avoid using information that would not have been available at the time. Ultimately, momentum investing is based on the idea that stocks moving in a particular direction may continue moving in that direction for some time. However, rising stocks do not always keep rising, and strong upward trends can suddenly turn into sharp declines. One important lesson from momentum investing is that stock prices are influenced not only by the underlying value of a business, but also by market trends and investor behavior. Understanding these forces can help us develop a broader perspective on why stock prices move the way they do.