Introduction
Momentum investing is a strategy that favors securities that have performed strongly relative to others, based on the idea that price trends can persist for a period of time. Instead of primarily asking whether a stock looks cheap or expensive, momentum investors focus on the direction and strength of recent performance.
Momentum has been studied across stocks and other asset classes and is also commonly treated as an investment factor. However, a trend can reverse quickly. The strategy can therefore produce sharp losses, especially when market leadership changes suddenly.
Momentum investing is systematic in many implementations, but there is no single universal definition. Measurement periods, portfolio rules, rebalancing, and risk controls can all change the results.
How momentum investing works
A basic momentum strategy ranks securities by their recent performance and favors those with stronger relative returns. Securities with weak momentum may receive smaller weights or be excluded.
Many systematic strategies use several months of price history rather than very short-term movements. Some approaches also exclude the most recent period because very short-term price behavior can differ from intermediate-term momentum.
The portfolio is periodically rebalanced because momentum changes. A stock that was previously a strong performer can fall out of the portfolio when its relative trend weakens.
Relative and absolute momentum
Relative momentum
Relative momentum compares securities with one another. A strategy might rank a group of stocks and favor those with the strongest recent performance relative to their peers.
Absolute momentum
Absolute momentum evaluates an asset against its own past performance or another reference point. It is often associated with trend-following approaches rather than ranking securities only against each other.
Why might momentum persist?
Researchers have proposed several explanations. Investors may react slowly to new information, causing prices to adjust over time rather than immediately. Investors may also chase recent winners, reinforcing existing trends.
Risk-based explanations are also possible. Momentum portfolios can have changing exposures and can suffer particularly severe losses during rapid market reversals.
No explanation means momentum is guaranteed to continue. Historical evidence describes past markets, while future returns remain uncertain.
Momentum versus value investing
| Characteristic | Momentum investing | Value investing |
|---|---|---|
| Primary signal | Recent relative price performance | Price relative to estimated fundamental value |
| Typical purchase | Recent outperformers | Apparently undervalued securities |
| Portfolio turnover | Often higher | Can be lower |
| Main danger | Rapid trend reversal | Value trap or incorrect valuation |
The approaches can sometimes point in opposite directions. A stock that has risen strongly may rank well on momentum while becoming less attractive on traditional valuation measures.
Neither approach automatically dominates the other. Some factor investing strategies combine momentum and value with other factors to diversify their sources of exposure.
Momentum is not simply buying what went up yesterday
Professional and systematic momentum strategies generally use defined measurement and portfolio rules. Reacting impulsively to a one-day price jump is not the same thing.
Short-term price movements contain substantial noise. A disciplined strategy defines how momentum is measured, when securities enter or leave the portfolio, how positions are sized, and how often the portfolio is rebalanced.
Without clear rules, investors can end up chasing performance after much of a move has already occurred.
Turnover and implementation costs
Momentum portfolios need to change as trends change. This can produce higher turnover than a broad buy-and-hold portfolio.
Trading creates bid-ask spreads and other transaction costs. In taxable accounts, selling appreciated positions can also create tax consequences. These implementation costs can reduce the return that remains after applying the strategy.
Costs are particularly important when a strategy trades frequently or holds less liquid securities.
Momentum crashes and reversals
One of the most important momentum risks is a rapid reversal. Recent winners can fall while recent losers rebound, causing a momentum portfolio to lose money quickly.
This can occur around major changes in market conditions, especially when a previous trend becomes crowded or investors rapidly change their expectations.
Diversification and position limits can reduce dependence on individual securities, but they cannot remove the underlying risk that the momentum factor itself performs poorly.
How investors can access momentum strategies
Investors can build rules-based portfolios themselves or use ETFs and mutual funds designed to provide momentum exposure. Fund methodologies vary considerably.
Important differences include the period used to measure momentum, whether volatility is considered, how often the portfolio rebalances, and how much weight individual stocks or sectors can receive.
For this reason, investors should examine the methodology rather than assuming every momentum fund provides the same exposure.
Risks of momentum investing
Momentum can underperform for extended periods and can experience abrupt losses when trends reverse. Higher turnover can increase trading costs and tax consequences, while frequent portfolio changes can make the strategy harder to follow consistently.
Momentum portfolios can also develop unintended concentrations. If one sector has recently dominated the market, a momentum strategy may become heavily exposed to that sector unless its rules impose limits.
Past performance is central to the signal, but past performance does not guarantee future results. A strong historical trend can end immediately after a position is purchased.
Key takeaways
- Momentum investing favors securities with relatively strong recent performance.
- Momentum can be measured in different ways, including relative and absolute approaches.
- Behavioral, risk-based, and market-structure explanations have been proposed for momentum.
- The strategy usually requires periodic rebalancing and can have relatively high turnover.
- Rapid trend reversals can cause substantial losses.
- Momentum is a systematic strategy when implemented with defined rules, not simply the practice of chasing short-term price increases.