When you throw a ball, it keeps moving in the same direction until friction and gravity pull it down. The stock market behaves similarly. Momentum investing is the strategy of buying stocks that are already going up, riding the trend, and selling them before the trend reverses.
In this article, we have momentum investing explained in simple terms—perfect for beginners looking to apply a quantitative approach to the Indian markets.
What is Momentum Investing?
At its core, momentum investing defies the old cliché "buy low, sell high." Instead, momentum investors buy high and sell higher. It is based on the empirical observation that stocks that have outperformed the market in the recent past tend to continue outperforming in the near future.
Unlike value investing, where you try to find undervalued companies, momentum investing doesn't care about what a company "should" be worth. It only cares about the price action and the strength of the trend.
Why Does Momentum Work?
You might wonder: if it's this simple, why doesn't everyone do it? Momentum works primarily due to behavioral biases in the market:
- Underreaction: Investors often underreact to positive news (like strong earnings). It takes time for the full impact to be priced in, creating a sustained upward trend.
- Herd Mentality: Institutional investors often build positions over weeks or months. Their sustained buying creates a momentum wave that retail traders can ride.
- Anchoring: People anchor to old prices. When a stock breaks out, skeptics wait for a "dip" that never comes, forcing them to buy later at even higher prices, pushing the stock up further.
How is Momentum Measured?
Instead of guessing, quantitative investors use a stock's historical returns to measure momentum. A common method used in the Indian market is looking at the past 3, 6, and 9-month returns, adjusted for volatility. This ensures you aren't just buying the most volatile stock, but the one with the steadiest upward climb.
"The trend is your friend." — A foundational rule of momentum investing.
Risks of Momentum Investing
While highly profitable, momentum isn't perfect. The biggest risk is a "momentum crash," which happens during sudden market reversals (like a sudden global crisis). When the broader market drops sharply, high-momentum stocks can fall violently as investors rush to lock in profits.
This is why risk management—like using market-wide moving averages to exit during crashes—is crucial for momentum traders.