October 23, 2020
By Rahul Iyer
Momentum investing refers to the practice of buying more of your best-performing assets. Instead of buying low and selling high, you keep what increases in value and sell assets that do not perform. The philosophy that drives this investment strategy is that proven trends will continue; therefore, putting more money into high-performing stocks will be likely to bring positive returns.
It is relatively easy to apply this strategy to your investment portfolio. An investor simply needs to identify which stocks in his or her portfolio are doing well. While this has its benefits, it can be a tedious task. Most people do not have the time, energy, or skills needed to determine which stocks are doing well in their portfolio. Momentum investing can get technical. This is the case when the strategy is being applied using complex technical indicators to identify which stocks are the top-performing assets.
There is no evidence that points to the originator of this investment strategy. An example of the strategy was uncovered in 1993. In 1993, there was a publication in the Journal of Finance in that year mentioned that if investors decided to purchase stocks that performed well in the past and disposed of stocks that were losing, they would position themselves for extravagant returns between 1965 and 1989.
There are a number of expert investment managers who do not readily support the use of momentum investing. They believe that selecting individual stocks based on an assessment of discounted cash flow and other critical factors usually produce results that can be easily predicted. Experts suggest that this practice is a better method for beating the index performance.
There are some risks involved in applying this strategy. Below are a number of them that you should consider.
Turnover: Momentum investing usually produces a high amount of turnover. This usually results in a few implications. Trading costs are one of these implications.
Taxes: As established, this method of investing typically results in high turnover, this turnover makes this strategy highly tax-inefficient.
The Risk of Implementation: Since there are so many aspects to monitor in the process of implementing this strategy, you expose yourself to more opportunities to make a bad choice.
Market Transitions: From time to time, the leader in the market changes. Sine momentum investing may not move as quickly, there can be challenges during times when these changes happen.
Momentum Crashes: History has taught us that from time to time, momentum can make a huge shift. This risk can result in you losing a lot of money.