To understand the pros and cons of investment momentum, it is helpful to understand just what “momentum investing” means. It’s a simple concept that’s strategy rests on following market trends already in motion. That is, with momentum investing, an investor seeks to gain by following “hot” trends or short-selling stocks that are on a downward trajectory. The rationale for this behavior lies in the belief that once a stock has begun to move in a certain direction, it is more likely to continue along that path than to reverse course.
Pros of Momentum Investing
Momentum investing (which is sometimes referred to as “fair weather investing”) relies on stock indicators from the past 3 to 12 months for clues to investment strategy. Under an investment momentum strategy, investors follow the herd to gain the best returns. Richard Driehaus, the Chief Investment Officer of the Chicago-based Driehaus Capital Management, is considered one of the pioneers of this investment strategy, turning the popular notion “buy low, sell high” on its head. According to Driehaus, “far more money is made buying high and selling at even higher prices.” Since Driehaus made this initial pronouncement, pundits have been quoting and applying this to any number of situations.
For many, there is some common sense to the strategy. Part of that centers around the herd mentality of investors. As anyone who has watched the markets knows, when a stock receives a jolt of bad news, it’s often hard to stop the downward momentum. Similarly when a stock is perceived to be “hot” (watch an IPO for a social networking tech stock, for example), investors will begin jumping on the bandwagon, often driving the stock to atmospheric rates, before it settles back down to a reasonable level.
In fact, many economists propose that investors are taking advantage of the shortcomings of other investors by using this strategy. For example, it plays into the phenomenon of “confirmation bias.” This is a situation in which the investor is looking for confirmation of his or her opinion regarding a stock, whether or not the perception is correct. If the investor believes the stock’s value is rising, the investor buys, despite the reality of the situation.
Also on the positive side of this strategy may be seasonal trends, which seem to play out to the advantage of an investor following momentum investing. For example, at the end of a year, if a stock has done badly, a trend may develop in which investors sell the stock for tax purposes, thus confirming an already downward trend.
Cons of Momentum Investing
Looking at the negative side of this strategy, it is easy to see that there is no basis in fact for an investor to buy or sell under this theory. It is based merely on the whims of the marketplace. The bad news for investors considering momentum investing is that the herd is often wrong; at any given moment, a stock can reverse itself, and the investor can lose big.
Economists cite the principle of Efficient Market Hypothesis (EMH) as reason enough to disregard this theory. EMH states that, given the public information available at the time of purchase of a stock, an investor cannot make “above average” returns consistently. This seems to fly in the face of “following the herd” on which momentum investing depends. After all, if it was that easy to make money in the stock market by following the crowd, there would be no need for investment pundits and prognosticators…or even theories for that matter.
Resistance and support are two key tools that investors can use when applying the momentum investment strategy. With resistance, the concept refers to a price level at which there is “push back.” That is, the price refuses to go higher. This is, in effect, a ceiling on the stock price, which should indicate to an investor that it is time to abandon a momentum investment way of thinking as the concept of “momentum” is no longer in play. With resistance, the price is unlikely to climb any further, and if the investor does not sell at that point, he or she is likely to suffer a loss.
Does the strategy of momentum investing work? There are supporters and detractors, but like any investment tools, it can be used to make gains (some say on average of 1 percent per month) some of the time. Some even say George Soros used a variation of this theory successfully in the 1960s and 1970s. For the average investor, however, the verdict may still be out.