What Momentum Investing Is and How It Works

Momentum investing is a popular strategy among both institutional and retail investors, driven by the idea that assets with recent strong performance may continue their trend and those that have fallen will continue to decline. While it may sound simple, momentum investing requires discipline, data-driven analysis, and a strong understanding of market psychology. In this article, we explore what momentum investing is, how it works, the concept of momentum factor investing, and the key advantages and risks to consider before using this strategy.

What Is Momentum Investing?

Momentum investing is an investment strategy that focuses on buying securities with upward price trends and selling or avoiding those with downward trends. It is rooted in one of the most well-documented market anomalies: asset prices tend to exhibit persistence in their movement. In other words, winners may continue to rise, and losers may continue to underperform at least in the short to medium term.

Unlike value investing, which seeks undervalued assets, or growth investing, which targets companies with high future potential, momentum investing is driven almost entirely by price behavior. The strategy assumes that market trends may persist for longer periods, creating opportunities to participate in them.

Momentum investing is also closely tied to behavioral finance principles. Market participants may react slowly to news, creating trends that build over time. Emotional biases such as fear of missing out (FOMO), herd behavior, and confirmation bias can further amplify price momentum.

Momentum Factor Investing

Momentum factor investing applies the same principles but uses a systematic, quantitative approach. It is most used in factor-based or smart beta portfolios that aim to outperform traditional market benchmarks.

In momentum factor investing, securities are ranked by their recent performance over defined time periods (typically 3, 6, or 12 months). Portfolios are then constructed by selecting assets with the strongest performance metrics while excluding those with weak or negative momentum.

This method reduces emotional decision-making and relies on consistent rules, making it attractive to quantitative funds, ETFs, and institutional managers. The "momentum factor" has been widely studied in academic research and is considered a well-researched factor alongside value, size, and quality, though it also exhibits periods of underperformance.

How Momentum Investing Works

Momentum investing relies on identifying and following price trends across stocks, commodities, indices, or other asset classes. The process generally includes:

1. Identifying the Trend

   Investors analyze historical price movements to determine whether an asset is exhibiting sustained upward or downward momentum. Common technical indicators include moving averages, the relative strength index (RSI), and the rate of change (ROC).

2. Confirming Strength

   Once a trend is identified, investors confirm its strength through volume analysis, breakout patterns, or momentum scores used in factor models.

3. Executing the Trade

   Momentum investing is described in academic literature as focusing on assets that have recently shown positive price movements and upward trends and may apply stop loss orders to manage downside risk. They avoid or sell assets showing negative momentum.

4. Monitoring and adjusting

   Momentum strategies require continuous monitoring. When trends weaken, investors may exit positions quickly. This active approach distinguishes momentum investing from longer-term strategies like value or buy and hold.

Benefits of Momentum Investing

1. Opportunity for Returns in Trending Markets

   While momentum strategies may perform well during trending markets, they also carry a risk of rapid reversals. Investors can capitalize on strong market direction rather than attempting to predict reversals.

2. Supported by Academic Research

   Decades of studies show that momentum is a persistent market anomaly. The momentum factor has historically delivered strong risk-adjusted returns across different markets and asset classes.

3. Works Across Multiple Asset Types

   Momentum investing is not limited to stocks. It can be applied to commodities, currencies, bonds, and ETFs, providing flexibility and diversification opportunities.

4. Removes Emotional Bias

   When done systematically, momentum investing reduces emotional decision-making. Traders follow data and pre set rules rather than reacting to market noise, fear, or excitement.

Risks of Momentum Investing

1. High Volatility

   Momentum strategies can be volatile, especially during sudden market reversals. Sharp corrections can lead to quick losses when trends break unexpectedly.

2. Higher Transaction Costs

   Frequent buying and selling can lead to increased transaction costs, bid-ask spreads, and potential tax implications, especially for active traders.

3. Crowded Trades

   Because momentum is widely used, many investors chase the same assets. This can amplify price swings and create crowded trades that unwind quickly when market sentiment shifts.

4. Vulnerable to Whipsaw Movements

   In sideways or choppy markets, momentum signals may provide false or inconsistent trends, leading to repeated buying and selling without clear profit opportunities.

Read also: Strategic Financial Planning for Sustainable Business

Is Momentum Investing Right for You?

Investors may evaluate momentum investing strategies differently depending on their preferences. Momentum investing may appeal to investors who are disciplined, comfortable with active management, and able to react quickly to changing market conditions. It is especially suitable for those who trust data-driven strategies and are willing to accept short-term volatility. However, investors with a low risk tolerance or a preference for long-term fundamentals may find momentum investing too reactive or unpredictable.

The Bottom Line

Momentum investing, whether practiced manually or through momentum factor investing, remains one of the most researched and widely studied investment strategies in academic literature. However, it may not suit all investor profiles.

By understanding what momentum investing is, how it works, and the balance of benefits and risks, investors can decide whether this approach aligns with their goals and risk tolerance.

While not without challenges, momentum strategies are designed to identify and follow trends, though they carry inherent risks and periods of underperformance.