Understanding Stock Market Momentum Investing

Momentum investing is a strategy that revolves around buying high, and selling even higher. While not necessarily as mathematically grounded a strategy as others, it has demonstrated itself time and again as being an extremely effective method of money management.

Specifically, studies have shown general returns of approximately 12%/year form portfolios that focus on momentum based investment. In this article, I’m going to go over the basics of how it is that momentum investing works, and why it is relevant to a personal investment portfolio.

Momentum trends stem from the observation that stocks tend to over-extend themselves in any directions which they are currently moving. If a stock is moving up, it tends to move up further then it maybe would have in a perfectly efficient market. What this essentially means is that stocks that have been increasing in the past will be more likely to continue increasing than other stocks that have previously been decreasing or remaining stagnant.

This presents us with an opportunity to purchase a stock during the middle of a rally, and then sell off in the ensuing period in which the stock will continue to rise after the initial catalyst. The end result? We are still able to profit from a major announcement, even though we didn’t buy in before the announcement was actually made. Sounds exciting right? So let’s get into the details about how it is that we can apply this to our own portfolios.

The biggest thing to remember when evaluating investments for our own personal accounts is that we should never just rely on a single investment strategy. Instead, we should focus on creating a robust portfolio by combining different strategies of evaluation to create a well-founded decision. Especially when dealing with a theory as flexible as those behind momentum investing, it is important to stay focused on the strategies that we are most familiar with.

Specifically, I tend to focus on value investing that is grounded in good fundamental analysis, and then I use momentum analysis to further refine my evaluations. I’ll always start by looking for some broad macro trends that I use to define how I generally want to allocated my funds within the portfolio itself. From there, I’ll start running some company screens on value metrics, to find those companies that present the best buying opportunities at current levels.

Lastly, I’ll sort through those screened companies for momentum, and discover which ones are most likely to demonstrate short-medium term growth based on momentum. Alternatively, I’ll consider holding off on purchasing stocks that demonstrate short-medium term downward momentum, and save them for later dates when the indicators are more favourable.

The trick to implementing momentum into a personal portfolio is to maintain value-based discipline, and to use momentum indicators only as a reference point to help you decide when to buy, and when to sell. With that in mind, I’ll go into greater detail in the next article by providing a couple of metrics that can be used for finding this entry points based on momentum.