The logic behind momentum investing Premium

Traditionally, experts have advised investors to buy assets when they are selling at low prices, such as during times of a financial crisis, as assets could be found selling at prices well below their intrinsic value. Momentum investing is in stark contrast to this traditional logic

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Momentum investing refers to a style of investing wherein investors purchase assets such as stocks or bonds that are consistently rising in price while selling assets whose prices are falling. Momentum investors buy assets with rising prices in the hope that the upward price momentum of these assets would continue, thus allowing them to sell these assets at higher prices in the future to make profits. Similarly, they sell assets that are falling in price expecting the fall in prices to continue for some time.

Momentum investing is based on the philosophy that there can be discernible trends in asset prices and that these trends tend to persist over time. The persistence of such trends gives investors an opportunity to recognise and participate in them early enough to make significant profits from their investments.

Counter-logic

Traditionally, experts have advised investors to buy assets when they are selling at low prices, such as during times of a financial crisis when most investors are scared and hence assets could be found selling at prices well below their intrinsic value. It was believed that investors could later sell these undervalued assets at higher prices when the general market enters a bull phase. The “buy high, sell higher” philosophy of momentum investing is in stark contrast to the traditional “buy low, sell high” advice given to investors. Momentum investors often invest money in assets whose prices have scaled new all-time highs, even if these assets are trading at prices that are far above their intrinsic value. Many academic studies have shown that momentum investing can generate high returns that comfortably beat the benchmark indices.

Momentum investors generally do not conduct a deep analysis of the fundamental or intrinsic value of the assets in which they invest their money. They invest purely based on whether the price of an asset is showing a strong trend, either upward or downward, that they can ride on. For this reason, many critics argue that momentum investing can cause an unsustainable rise or fall in prices as momentum investors are blind to the actual value of these assets. This, they argue, can eventually lead to heavy losses for investors who are late to sell when the prices of these momentum-driven assets correct suddenly to catch up with the assets’ intrinsic value.

Some investors may combine value investing, which is based on assessing the intrinsic value of an asset, with momentum investing. These investors believe that taking into account the existing trend in the price of an asset can help save time and boost investment returns. It should be noted that traditional value investors believe in purchasing assets that are undervalued and selling them when the price of the asset has risen to match the asset’s intrinsic value. It might, however, take many years before the price of an asset rises to fully match its intrinsic value.

Investors who combine value investing with momentum investing may be able to purchase an undervalued asset at just about the time when its price starts to trend towards its intrinsic value. This prevents investor money from being locked in for years in assets whose prices go nowhere.

Value in index funds

Momentum investors also argue that passive investing strategies that recommend investing in benchmark indices such as the Dow Jones and the S&P 500 through index funds are in reality based on momentum. Many value investors, including American billionaire Warren Buffett, have recommended retail investors to invest in index funds that mimic these benchmark indices arguing that these indices are composed of high-quality companies that have shown consistent earnings growth. But the actual construction of these indices, it should be noted, is not based on the earnings of companies, but based on their market capitalisation. India’s Nifty 50, for instance, is basically a collection of stocks whose prices have consistently risen over time and made them one of the top 50 companies in the market in terms of market capitalisation.

Momentum investors, it should be noted, use a variety of methods to gauge an asset’s price momentum. The simplest method of momentum investing is to buy assets whose prices have shown the highest percentage gains over the last three to six months while selling assets whose prices have witnessed the steepest percentage losses. An asset’s price momentum can also be gauged by analysing how well the asset’s price has performed compared to the benchmark indices. More sophisticated momentum investors might look into the price chart of an asset and try to gauge the strength of the upward or downward trend exhibited by the asset’s price.

The price of an asset may not always trend, however. It can just move sideways, and during such times momentum investors may decide to stay away from the market and simply hold cash.