Most stocks make some kind of decisive move every year. This move, according to the philosophy behind momentum investing, follows the 80-20 adage: The stocks exhibit about 80% of their movement over 20% of the time. There are always those high flyers that seem to have 1 to 2 years of hyper-performance, but, generally speaking, most stocks have a “burst” of movement during a relatively short period. Fortunately for investors, different stocks seem to move at different times.
The goal of the momentum investor is to try to capitalize on diversified portfolio of fast movers. The key to momentum investing is to find the stocks that are moving now and be in on them while they are moving. Ideally, the momentum investor tries to catch the biggest waves, jump on at the “perfect” time, and get off at the “perfect” time — which would be just before the momentum reverses or, more likely, just after the momentum reverses. Perfect timing is impossible, of course, but getting in near the beginning of the upward momentum and getting out before it stops or shortly after it reverses is the ultimate objective.
The Faster They Move, the Harder They May Fall
There is a fair amount of risk in attempting this kind of investment because stocks with momentum are typically the ones that have come the farthest the fastest. Often they will be at new highs and sometimes very pricey, and the inevitable correction can be swift and painful. But successful momentum investors typically are not afraid to buy a stock at a new high because, as William O’Neil, publisher of Investor’s Business Daily and a leading momentum guru, says, a stock has to reach a new high to go higher. Just keep in mind that not every trade is going to be successful, and one of the important caveats for momentum investors is to take your losses quickly.
Personality Traits of the Momentum Investor
Those who are attracted to momentum investing expect big rewards and they expect them quickly. There is perhaps no equity investing style that offers the potential to earn as much — as quickly — as does momentum investing. Most of the extraordinary gains reported by momentum investors come from those who switch among many stocks over a period of a year, trying to capture gains from as many as possible. Those who do it well often see exceptional returns. But with great reward usually goes great risk, so it should come as no surprise that momentum investing is one of the higher-risk strategies. Stocks that are on a momentum roll frequently have had extraordinary earnings announcements, and any hint that the earnings growth might not continue can stop them in their tracks on any given day. As a result, momentum stocks can take some pretty big drops.
Perhaps the most important characteristic of the momentum investor is the need for discipline. Because of the need to get in and out of a stock quickly, a momentum investor must have the discipline to act decisively on entry and exit signals, even when the exit signal is telling you to get out of a stock you’ve only recently entered and you know you’ll suffer a loss. Learning to take quick losses can save you from suffering larger losses in the future. In the quick-moving, short-term world of the momentum investor, one who hesitates or second-guesses him or herself will likely fall short of one’s goals. Momentum investing requires a heavy time commitment, probably more so than any other major style of stock investing. When building a momentum portfolio, you have to survey dozens of stocks in order to identify those with the best momentum, and you must be prepared to act quickly in order to enjoy as much of the ride as you can.
But with a portfolio of momentum stocks, you can’t afford to rest on your laurels. Once you have invested, you must look at daily charts of the stocks you own so you can get off when the ride is over. Also you should monitor a watch list of potential stocks, so that when you see one that has better momentum characteristics than a stock you currently own, you can make a quick switch. That means comparing a lot of stocks and industry groups on a daily basis. While charting skills are important, the best momentum runs normally follow good earnings reports, so you can’t be just a chart person; you will also need to compare earnings reports, so your quantitative skills should also be good.
Compared with value and growth investing, momentum investing scores somewhat lower in terms of the degree of confidence the investor should have. As a momentum investor, you must act quickly and decisively, but once you’ve learned to spot a momentum stock and learned your rules for entry and exit — in other words, once you’ve built a “mechanical trading system”— you don’t have to make tough judgment calls on a daily basis. Your system will make those decisions for you. In that sense, momentum investing is basically a juggling act. You have to keep a lot of balls in the air at one time and know when to let a ball go and when to exchange a red ball for a green one.
Momentum investing is a style for investors who don’t like agonizing over the kinds of questions that often stymie growth and value investors: Is this a reasonable price for this level of earnings growth? Has this undervalued stock truly begun a recovery? Momentum investors can just go by the numbers: Buy when the signal says buy; sell when the signal says sell. The key is to monitor your stocks daily for signals that indicate an appropriate time to sell.