Advantages of Momentum Investing
One of the best features of momentum investing is that it allows you to capitalize on prevailing market trends. Momentum strategies, especially in the stock market, have done exceedingly well over the last few decades as per statistical studies. However, the level of underperformance was severe since 2019. Momentum strategies typically deliver 8-12% annualized returns, which is better than the vast majority of other strategies. Momentum investors look to capture the opportunities associated with a market that can fluctuate both upwards and downwards by identifying and then following these price trends. This kind of market leads to greater success with momentum strategies because uptrends end only about 30% of the time when they have just started (taking into account all bull markets).
For momentum investors, the duration of time that they hold the asset is typically brief. Simply stated, they are trying to get in and out of a move before the trend is over. Evidence suggests that momentum has an advantage for short-term holding strategies (typically only 3-12 months), which can largely dodge the most brutal episodes where markets reverse. This was observed during the market crash in early 2020 from the pandemic, where momentum performed better than long-term investors as they could exit downtrends more quickly.
Momentum investing is not restricted to the stock market but prevalent in other markets as well, such as foreign exchange, futures, and cryptocurrencies. Academic research has shown that foreign exchange momentum strategies can generate returns of 10% to 15% per year. Due to the high volatility in the cryptocurrency markets, momentum strategies can have annualized returns reaching 20-30%. In plain terms, this means that momentum investors can find opportunities anywhere in the markets since they operate around volatility and trend patterns between different asset classes.
Risks of Momentum Investing
Although momentum strategies work in many markets, the market trends do not run forever. Research shows that 30% to 40% of momentum strategies may face significant losses (reversal). Momentum investors tend to have very high peak-to-trough drawdowns once the economic mood changes abruptly. This was illustrated by the high concentration and poor liquidity of many momentum strategies, which led to significant losses greater than 15% in just a few weeks when U.S. stock markets tumbled sharply in early 2018. This makes momentum investing less potent during bear markets or in range-bound trading.
The reliance of momentum investors on market sentiment is another issue. Sharply reversing market sentiment can turn markets against the momentum effect very quickly. Momentum strategies are also more affected by macro events such as central bank policy changes or geopolitical stress. Momentum is associated with a lot of behavioral biases, and this means that momentum investors need to keep an eye on market dynamics all the time to avoid being caught in trend reversals.
Momentum investing frequently involves buying and selling stocks. Studies have shown that momentum strategies could close 12 to 20 round-trips in a year, compared with only up to three trades of the traditional buy-and-hold approach over the same time period. Of course, the more you trade and transfer money around—especially in today’s world of high brokerage commissions, spreads, and taxes on capital gains—these add up to be a heavy cost. Based on recent research, transaction costs are estimated to eat into 2%-5% of momentum investors’ annualized returns—a large enough slice that it could cut into long-term gains potential.
Suitable Investor Types for Momentum Investing
Momentum investing is best for those who are able to quickly integrate new information and take on higher risks. Data confirms that the annual volatility of investors who use momentum strategies can be 15% to as much as 20%, far higher than returns for major stock indexes that tend to be closer to 10% or 15%. As such, these investors must manage risk rigorously and avoid getting caught up in the emotional aspects of short-term market movements.
