Momentum Investing Strategy: How to Ride Market Trends

Momentum investing is based on a simple but powerful idea: stocks that have been performing well tend to continue performing well, and stocks that have been performing poorly tend to continue underperforming. This guide explains how momentum investing works and how you can use it to potentially enhance your returns.

What is Momentum Investing?

Momentum investing is a strategy that involves buying securities that have had high returns over the past three to twelve months and selling those that have had poor returns over the same period. The strategy is based on the observation that trends in stock prices tend to persist for some time before reversing.

Why Momentum Works

Academic research has consistently shown that momentum is one of the most persistent market anomalies. Several factors explain why momentum exists:

Behavioral Factors

• Underreaction: Investors initially underreact to positive news, causing prices to rise slowly
• Herding: As prices rise, more investors pile in, pushing prices higher
• Confirmation Bias: Investors seek information that confirms the current trend
• Anchoring: Investors anchor to past prices and slowly adjust expectations

Institutional Factors

• Gradual Position Building: Large institutions must buy slowly, extending price trends
• Performance Chasing: Fund flows follow recent performance, reinforcing trends
• Index Rebalancing: Index additions can create sustained buying pressure

Key Momentum Indicators

Relative Strength

Relative strength compares a stock's performance to a benchmark (usually the S&P 500) or other stocks in its sector. Stocks with strong relative strength are outperforming their peers and may continue to do so.

Momentum Investing Strategies

1. Time-Series Momentum

This approach looks at a stock's own past performance. If a stock has positive returns over the lookback period (typically 3-12 months), you buy it. If returns are negative, you avoid or short it.

2. Cross-Sectional Momentum

This strategy ranks all stocks by their past performance and buys the top performers while avoiding or shorting the worst performers. You are betting on relative performance rather than absolute returns.

3. Dual Momentum

Developed by Gary Antonacci, dual momentum combines both approaches:

• First, check if the asset has positive absolute momentum (beating cash)
• Then, compare relative momentum against alternatives
• Only invest when both conditions are favorable

4. Sector Rotation

Apply momentum to sectors rather than individual stocks. Rotate into the strongest performing sectors and out of the weakest. This approach can reduce single-stock risk while capturing momentum effects.

Implementing a Momentum Strategy

Step 1: Define Your Lookback Period

Research suggests 3-12 months works best. Many investors use 6 or 12 months. Shorter periods are noisier, while longer periods may miss trend changes.

Step 2: Set Selection Criteria

• Rank stocks by past returns over your lookback period
• Select the top 10-20% of performers
• Consider excluding the most recent month (reduces short-term reversal effects)
• Apply liquidity filters to ensure tradability

Step 3: Establish Rebalancing Schedule

Monthly rebalancing is common, though quarterly can reduce transaction costs. More frequent rebalancing captures momentum changes faster but incurs more costs.

Step 4: Set Risk Management Rules

• Limit position sizes to manage concentration risk
• Use stop-losses to exit positions when momentum fades
• Consider reducing exposure during bear markets

Combining Momentum with Other Strategies

Growth and Momentum

Many successful investors combine growth fundamentals with price momentum. They look for companies with strong earnings growth that are also showing technical strength.

Value and Momentum

This counterintuitive combination can work well. Find undervalued stocks that are starting to show positive momentum, suggesting the market is beginning to recognize their value.

Quality and Momentum

Combining high-quality companies (strong ROE, low debt, stable earnings) with momentum can reduce volatility while maintaining upside potential.

Risks of Momentum Investing

• Momentum Crashes: Momentum strategies can suffer severe losses when trends reverse suddenly
• High Turnover: Frequent trading increases transaction costs and tax implications
• Volatility: Momentum portfolios tend to be more volatile than the broader market
• Crowding: Popular momentum strategies may become crowded, reducing effectiveness
• Timing Risk: Entering late in a trend increases the risk of reversal losses

Tools for Momentum Investing

Stock Screeners

Use screeners to filter for stocks with:

• Strong 6-month or 12-month returns
• Price above 50-day and 200-day moving averages
• High relative strength vs. the market
• Increasing volume on up days

Technical Charts

Review charts for:

• Clear uptrends with higher highs and higher lows
• Moving average alignment (50-day above 200-day)
• Momentum indicator confirmations (RSI, MACD)
• Breakouts from consolidation patterns

Famous Momentum Investors

• Richard Driehaus: Pioneer of momentum investing, averaged 30%+ returns
• William O'Neil: CANSLIM system incorporates strong momentum elements
• Gary Antonacci: Developer of dual momentum strategy
• AQR Capital: Quantitative firm that extensively researches momentum

Summary

Momentum investing exploits the tendency of winning stocks to keep winning and losing stocks to keep losing. By systematically buying strong performers and avoiding weak ones, momentum investors can potentially enhance returns. However, the strategy requires discipline, risk management, and the ability to withstand periods of underperformance when trends reverse. Consider combining momentum with other strategies like value or quality for a more robust approach.

Learn more trading strategies in our guides on growth investing or explore technical analysis fundamentals.