Momentum Investing
Momentum investing is an investment strategy that aims to capitalize on the continuance of existing market trends. In this strategy, investors buy stocks or other securities that have shown an upward trend in price and sell those that have had poor returns over a specified period, typically the past three to twelve months. This approach is grounded in the belief that securities that have performed well in the past will continue to do so in the near future, fueled by investor psychology and behavioral biases, such as the herd mentality.
Historical Background
The concept of momentum investing has roots in various academic theories and practical applications. It was popularized by Richard Driehaus, often considered the father of momentum investing. Another notable figure is Sheridan Titman, whose research significantly contributed to its understanding.
Mechanisms of Momentum Investing
Momentum investing depends on the belief in the persistence of price trends, driven by the efficient market hypothesis. Under this hypothesis, securities continually reflect all available information, and trends persist because new information is gradually incorporated into prices.
Investors using momentum strategies typically utilize quantitative models to identify and exploit these trends. Common metrics involve examining past price performance and volatility to forecast future movements.
Factor Models
Momentum is one of the factors in several financial models, including the Carhart four-factor model, which builds on the Fama–French three-factor model by adding a momentum factor. This model accounts for various influences on asset returns, including market risk, company size, and value factors.
Risks and Challenges
While potentially lucrative, momentum investing carries inherent risks, such as the risk of a momentum crash, where rapid reversals in price trends can result in significant losses. Factor investing strategies, including momentum, often require careful risk management and diversification to mitigate these risks.
Behavioral Factors
Momentum investing is closely linked to behavioral finance, a field that examines how psychological factors influence market outcomes. Investors may overreact or underreact to new information, causing securities to become mispriced temporarily.
Variations and Related Strategies
Momentum investing can be combined with other investment strategies to enhance returns and reduce risk. For instance, the Conservative Formula Investing method combines momentum with low-volatility and net payout approaches.
Related strategies include value investing, growth investing, and low-volatility investing, each with unique principles and methodologies but sometimes sharing elements with momentum investing.
Investment Vehicles
Momentum strategies can be executed through various investment vehicles, such as mutual funds, exchange-traded funds (ETFs), and hedge funds. These vehicles provide investors with different levels of exposure and risk management options.