Everything You Need to Know About Momentum Investing

Momentum investing has gained significant attraction among investors in recent years. This strategy, which involves capitalizing on the upward price trends of stocks, has become a popular choice for those looking to optimize their returns. Understanding momentum investing is crucial for mutual fund investors, especially those in Tier II and Tier III cities in India (Tier II and Tier III cities in India are the smaller urban centre’s experiencing growth and development, having population of Tier II cities range between 50000 to 99999 and Tier III cities range between 20000 to 49999), who are keen on exploring diverse investment strategies.

Momentum investing is based on the principle of buying stocks that have shown an upward price trend and selling those that have shown a downward trend. The idea is that stocks that have performed well in the past are likely to continue performing well in the near future, while those that have underperformed will continue to do so. This strategy relies on the belief that trends will persist due to investor behaviour, market psychology, or fundamental factors driving the price movements.

What is Momentum Investing?

Momentum investing is a strategy where investors buy securities that have shown recent positive price trends and sell those that have shown negative trends. The underlying idea is that assets that have performed well in the past are likely to continue performing well in the near future, while those that have performed poorly will continue to underperform. This strategy contrasts with other strategies like value investing, which focuses on buying undervalued assets regardless of recent price movements.

How Momentum Investing Works

Identifying momentum stocks involves analyzing price charts, identifying trends, and using technical indicators such as moving averages, relative strength (RSI), and momentum indicators. Momentum scores are used to evaluate stocks, with higher scores indicating stronger momentum. The typical time frames used in momentum investing can vary, with some investors focusing on short-term trends while others may look at longer-term trends.

For example, a stock that has consistently outperformed the market over the past six months may be considered a momentum stock. Investors would buy this stock with the expectation that its upward trend will continue. Conversely, a stock that has underperformed may be sold or avoided. However, past performance of a security does not guarantee any future performance.

Benefits of Momentum Investing

Momentum investing offers several potential benefits:

1. Better Return Potential: Momentum schemes may have the ability to provide relatively better returns than other mutual fund schemes due to their focus on high-performing stocks.
2. Capitalizing on Market Trends: By riding the upward trends of stocks, investors can capitalize on market movements and ability to achieve relatively better returns.
3. Diversification: Momentum schemes can offer diversification benefits as they can invest in a broad array of different companies that have shown a recent price surge. They can form a part of a diversified portfolio that also includes more stable schemes to balance risk and better reward.

Risks and Challenges of Momentum Investing

While momentum investing can be lucrative, it comes with its own set of risks:

1. Reversal Risk: Momentum schemes are highly volatile compared to other mutual fund schemes, as they invest in stocks that have shown rapid price appreciation. However, there is a high risk of a trend reversal. Markets are inherently unpredictable, and asset prices that have exhibited strong recent momentum may suddenly plummet.
2. Overvaluation Risk: Herd investing may lead to prices becoming detached from an asset’s underlying fundamentals, leading to bubbles. When such market bubbles burst, they can cause sharp corrections in asset values.
3. High Volatility: The stocks included in momentum schemes can exhibit strong momentum both towards the upside and the downside, leading to extreme swings in portfolio value. Investors must have a very high risk appetite to tide over such fluctuations. (You are recommended to seek advice from financial advisor before you take any/refrain from any action)

Momentum Investing in Mutual Fund schemes

Mutual fund schemes can incorporate momentum investing strategies by identifying and managing momentum stocks. Fund managers play a crucial role in this process, using their expertise to select stocks that have shown strong upward price trends. Investing in mutual fund schemes that use momentum strategies offers benefits such as professional management and diversification.

Also, these schemes are launched under the category of Index Funds with the objective to replicate/track the underlying Index. For instance, many momentum schemes in India are schemes, where the portfolio is designed to replicate an index such as Nifty200 Momentum 30 and Nifty Smallcap250 Momentum Quality 100, etc. Fund managers may also incorporate a momentum investing strategy while designing their portfolio in other equity schemes.

Tips for Investors Considering Momentum Investing

If you are considering momentum investing, here are some practical tips:

1. Stay Informed: Keep yourself updated with market trends and financial news. Understanding the market environment is crucial for momentum investing.
2. Set Clear Investment Goals: Define your investment objectives and risk tolerance. This will help you make informed decisions and stay focused on your goals.
3. Continuous Learning: Momentum investing requires a good understanding of market dynamics. Continuously educate yourself about different investment strategies and market trends.
4. Consult Financial Advisors: Before making any investment decisions, it is advisable to consult with financial advisors who can provide personalized advice based on your financial situation and goals.

Conclusion

Momentum investing offers a unique investment opportunity for investors with a high risk appetite who are seeking the potential for relatively better returns. By focusing on stocks that have shown strong upward price trends in the recent past, momentum investing can provide significant returns when market conditions are favourable. However, it is important to understand the risks associated with this strategy and to carefully consider whether it aligns with your investment goals and risk tolerance.

Momentum investing can be a powerful strategy for those who understand its principles and are willing to accept the associated risks. By staying informed and making informed decisions, investors can potentially achieve better returns and capitalize on market trends.

Additional links

What is a Mutual Fund? - Beginner's Guide to Investing

AMFI - Introduction to Mutual Funds

Know everything about SIP