The Strategy of Momentum Investing
Momentum investing is a style in which the investor looks for stocks that have been aggressively trending in an attempt to exploit opportunities from this current sentiment. The idea behind momentum investing is that when a trend is established, it is more likely to continue in that direction than to reverse. Under this strategy, the momentum investor looks to capture gains by riding stocks that are performing well and selling stocks in decline. Companies that are experiencing high growth in returns are also candidates for momentum investors. In executing the momentum approach, the investor will acquire a stock that is in an uptrend or short-sell a stock in a downward trend.
How a Momentum Investor Operates
Momentum investors will usually target stocks that have experienced high price changes in recent months, with the assumption that these companies will continue to show strong earnings and stock price appreciation. Momentum investors will typically hold the stock as long as its price continues to rise. As soon as the stock price begins to fall, they will sell and search out the next momentum candidate.
As with any investing strategy, the success of a momentum investor is dependent upon the timing of their actions. The momentum approach becomes particularly challenging in volatile, unstable markets in which price trends are difficult to identify and predict.
The Risks of Momentum Investing
The strategy is not without its risks as stocks that are likely candidates for acquisition by momentum investors usually have a significant following and possibly already trade at a high P/E ratio. This can leave the stock vulnerable to a significant decrease if earnings expectations are not met. If there is a hint of bad news, buyers may scramble to get out as quickly as possible. And while momentum investors can all jump in at the same time, they cannot all sell at the same time. In this scenario, share prices can plummet before the many investors have time to react.
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The above information is educational and should not be interpreted as financial advice. For advice that is specific to your circumstances, you should consult a financial or tax advisor.
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