Momentum investing: What is it and what are the main risks involved in following this investment approach? (2024)

Momentum investing, a widely adopted investment approach, seeks to generate profits by capitalising on upward trends while steering clear of assets on a downward trajectory.

This investing strategy involves prioritising the purchase of assets experiencing upward momentum and selling them when indications suggest a weakening trend. The fundamental concept is rooted in the belief that trends exhibit persistence, implying that if a stock or asset is on an upward trajectory, it is more likely to continue rising than to abruptly reverse direction. Typically, momentum investors employ technical analysis techniques, examining charts and indicators like moving averages and the relative strength index (RSI) to pinpoint trends and potential entry or exit points. Beginners in the market often adopt this strategy based on insights provided by financial experts, whether online or offline.

Why do investors employ momentum investing?

In contrast to alternative investment approaches, momentum investing can be a relatively straightforward strategy to execute, particularly when compared to the complexities of fundamental analysis, which requires a thorough examination of a company’s financials and business outlook. This approach can yield substantial returns, particularly during bullish market conditions when trends are robust and enduring.

Momentum investors hold the belief that once a trend, whether upward or downward, takes shape, it is likely to persist for a certain period. Their strategy involves purchasing assets on the rise and divesting those on a downward trajectory, to capitalise on and profit from these trends.

Momentum strategies leverage investor psychology, specifically the effects of herd mentality and the fear of missing out (FOMO). When a significant number of investors perceive a trend as robust, additional participants join in, further propelling prices in that direction. This dynamic is exploited by momentum investors for potential gains.

What are the risks involved?

There are inherent risks in momentum investing, as with any other investment approach. Some of the potential risks associated with this strategy include:

• Reversals in the market: Since trends are not permanent, there is a constant risk that the market might change direction, resulting in potential losses for momentum investors. Momentum investors purchase stocks that have experienced recent price increases, anticipating the continuation of the upward trend. Nevertheless, it’s essential to recognise that past performance doesn’t guarantee future outcomes. Trends have the potential to reverse, and without caution, such reversals can result in substantial losses.

Momentum strategies are prone to herd mentality, where investors join in on purchasing a surging stock merely because others are doing so. This collective behaviour can drive prices to unsustainable heights, rendering them more exposed to a sudden and significant correction. Surprising news, economic data, or unforeseen events have the potential to prompt swift shifts in investor sentiment, leading even robust trends to reverse rapidly.

• Market volatility: Engaging in momentum investing can be characterised by fluctuations, given its frequent buying and selling of assets. This dynamic nature may induce stress among certain investors and result in increased transaction costs.

This is because momentum strategies frequently entail active trading, swiftly entering and exiting positions to seize short-term trends. Such practices can result in substantial fluctuations in portfolio value, causing stress for investors who favour a more stable investment journey.

By concentrating on recent price shifts, momentum investors become more vulnerable to market noise and temporary price fluctuations. This heightened sensitivity can increase volatility and pose challenges in adhering to a long-term investment strategy.

• Psychological factors: Momentum investors may be influenced by behavioural biases, including the tendency to pursue trending stocks or sell prematurely due to the fear of missing out on potential profits. Such unwarranted biases can exert a notable influence on momentum investing, possibly resulting in less-than-ideal outcomes. This entails purchasing stocks that have already experienced substantial price hikes, with the expectation of capitalising on the ongoing momentum. Such an approach may involve acquiring assets at inflated prices, heightening the risk of losses in the event of a trend reversal.

Utilising momentum investing can serve as a valuable strategy for investors aiming to leverage prevailing trends. However, it is essential to carefully assess both its benefits and possible drawbacks. In essence, this technique is typically viewed as a short-term strategy, aiming to seize rapid profits from prevailing trends. As opposed to many investors viewing this method as an easy way to earn from the market, investing based on market trends doesn’t assure automatic wealth accumulation, emphasising the necessity to conduct thorough research before committing any funds.

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Published: 12 Feb 2024, 07:10 PM IST