What Is Momentum Investing?

What Is Momentum Investing?

Momentum investing is based on the assumption that market trends are more likely to continue their current trend from any given point in time. It's true that market trends will reverse, but this statistically occurs less often than a continuation of the trend. 

The strategy runs contrary to the notion of buying stocks that are undervalued because it assumes that the market is recognizing future growth potential. Some analysts have described momentum investing as "buying high and selling higher" in an effort to beat market averages. It might sound strange, but the idea has some merit.

How Does Momentum Investing Work?

Applying momentum investing strategies to your portfolio is easy to do. You just have to pick a time frame to measure, and then assess all the stocks you owned during that time.

One drawback of momentum investing is that it can require a good deal of work. Not all investors have the time, energy, or expertise to research which stocks have been on a good run and which have not. This is especially true for more detailed momentum investing techniques, which involve following certain complex technical indicators that tell you when to buy and sell a security.

However, the momentum philosophy can also be applied in a general way. Investors don't need to calculate financial indicators for individual stocks, they can simply put more money into stock index exchange-traded funds (ETFs) when the overall market is doing well. This applies the momentum investing strategy of riding trends in a broader sense.

History of Momentum Investing

It’s unclear who “invented” momentum investing, but an early example of it could be traced back to 1993. That was the year that researchers noted in the Journal of Finance that, if an investor purchased past winners and sold past losers, they would have received “significant abnormal returns” between 1965 and 1989.

This idea was picked up by Chicago-based fund manager Richard Driehaus about a decade later. In 2004, he told Crain's Chicago Business, “I believe that more money can be made buying high and selling at even higher prices. I try to buy stocks that have already had good price moves, that are often making new highs and that have positive relative strength.”

Momentum Investing Returns

One way to track the success of momentum investing is to look at the MSCI USA Momentum Index, which is designed to emphasize stocks with rising prices. Here’s a look at the annual performance of the MSCI USA Momentum Index compared to its parent index, the MSCI USA Index, as well as the S&P 500.

Past performance is never a guarantee of future returns, but with that in mind, one can form general theories about the patterns of these indices. As you can see, the MSCI USA Momentum Index beat the other two indexes in the seven years between 2008 and 2019. However, it is notable that, during the year of the financial crisis in 2008, the index performed worse than other indices. This suggests that momentum investing can add to growth during periods of good stock market growth, but it may fail to protect capital during bad times.