Equity investing: What makes momentum investing viable?

High momentum is exhibited in the market when the price advances or declines over a wide range in a short period of time.

Momentum investing is a strategy which is built on the simple assumption that financial assets such as shares, indices, derivatives, bonds, commodities that are showing strength will continue to go up at least in the short term, so we buy those those securities while selling those assets that are showing low returns. Thus, having a portfolio of such assets should offer better returns than that of the broader market return. Let us discuss the same in detail.

Mechanics behind momentum investing
This investment strategy is not new. The mechanics behind this strategy is based on the investment philosophy of cutting your losses and letting your winners ride. In other words, the concept of momentum investing states that short-term performance is repeated with winners continuing to be winners and losers continuing to be the losers. It is purely based when price action momentum is high. High momentum is exhibited in the market when the price advances or declines over a wide range in a short period of time.

Cause of momentum effect
According to behavioural finance literature, investors often overreact or underreact to information which leads to price changes and thus lead to price inefficiencies. Another plausible reason could be the market timing. For instance, investors may react very slowly in response to new information regarding a stock and then realise the importance and act hurriedly upon it, which creates momentum. Generally, such momentum exists for a short-term, i.e., between six to 12 months.

Types of momentum
There are two types of momentum investing strategies—time-series or absolute momentum and cross-sectional momentum. Under time-series momentum, the performance of an asset is compared to its own historical performance. For instance, ranking of shares on their own 12- month performance would provide a list of shares that have rallied the most.

Time-series momentum could be identified by keeping a certain profit percentage as threshold, and generally those shares / assets which have exceeded the threshold are bought. In case of relative momentum, the concerned assets performance is compared with other comparable asset classes. For instance, gold rallied over a year by 15% whereas equity rallied 12% during the same period. So, the relative momentum of gold is higher than that of equities.

Advantages and associated risks

Momentum investing is different from that of the traditional value investing philosophy of buying low and selling high. The major advantage of this strategy is that investors are buying an asset which is already moving up. So, there is no need to identify an undervalued asset and wait for the market to recognise the same to make profit. Another advantage is that there exists a potential for high profits within a short span of time. As investors are making use of the market volatility to their advantage, the momentum investing helps to maximise the return on investment.
Investors should understand the associated risks of following momentum investment strategy. Under this method, one is investing in an asset class purely based on recent buying behaviour of other market participants. There is no assurance that such buying behaviour will continue to push the price higher.

A large amount of empirical evidence and back-testing methods support that momentum trading strategies are profitable and while using such strategies investors should keep in mind the above discussed aspects.

The write is a professor of finance & accounting, IIM Tiruchirappalli