Momentum investing is about following the current direction of the market while staying with high-performing stocks and selling when that momentum starts to weaken.

How does momentum investing work?

At its core, momentum investing is based on a simple idea: when a stock’s price starts going up, it often keeps going up for some time. More people notice the rise, more people buy it and the price continues to increase. But this doesn’t last forever with the momentum slowing down and eventually affecting the price to fall. A momentum investor aims to capture gains during the upward trend and sell before the trend starts reversing. Technical indicators, such as moving averages and the relative strength index (RSI), serve as a reference point in this strategy.

The ACE framework for momentum investing:

• Analyse: Identify stocks with strong upward momentum using technical indicators like moving averages and the Relative Strength Index (RSI)
• Capitalise: Enter positions in trending stocks before they peak, leveraging short- to mid-term price movements.
• Exit: Monitor signals that indicate the momentum is fading and exit before the trend reverses.

Since this strategy thrives on short-term price movements, investors must stay vigilant and adjust their portfolios accordingly.

What are momentum funds, and how do they work?

For investors seeking exposure to momentum strategies without directly managing individual stock selection, momentum funds offer a viable alternative. These are actively managed mutual funds that concentrate on assets exhibiting strong price trends. Typically, these equity funds invest in stocks demonstrating upward price movement over the preceding six to twelve months. Fund managers play a critical role, continuously monitoring market dynamics to pinpoint stocks with robust recent price appreciation. The portfolio is updated often by removing underperforming stocks and adding those with rising momentum.

What are the differences between momentum investing and trend following?

While both momentum investing and trend following seek to capitalise on price movements, they differ in scope and timeframe. Momentum investing is generally a shorter-term strategy, focusing on recent price strength relative to other assets within the same class. It thrives within asset classes like equities. Trend following, conversely, adopts a longer-term perspective, analysing the overall direction of an asset's price. Its application is broader, spanning various investment types, including stocks, bonds, and commodities. Instead of relative comparisons, trend following assesses whether an asset's price is generally trending upwards or downwards. Below table will summarise the differences between momentum investing and trend following:

What are the advantages of momentum investing?

Easier decision making

Momentum Investing does not require you to do any complicated analysis of the companies. A decision can be made based on the momentum in the price and the strength of this momentum. Although you are not required to possess extensive financial knowledge, but you should still be able to know when to exit the stock.

Potential for high returns

Momentum investing offers the opportunity to achieve substantial gains as you focus on stocks that are already on an upward trajectory. The underlying assumption is that when the stock is trending upwards, it will attract more investors. This will increase the price of the stock. So smartly exiting the stock could deliver substantial returns on your investment.

Leveraging market volatility

During market volatility, you may leverage the short-term price movements of the stocks to make some gains. Therefore, momentum investing might shield your overall portfolio from market volatility.

Is momentum investing right for you?

As the whole idea of momentum investing is to assess the strength of the trend, momentum investing requires a constant monitoring of the stock market. Even a small delay could erode your gains. But if you are experienced in identifying the trends then you may engage in momentum investing. If you are an experienced investor and looking to diversify your portfolio beyond traditional equity options, momentum investing may be right for you.

If you are new to investing or lack the experience to spot momentum shifts in stocks, this strategy may not be the best fit. However, you may consider momentum mutual funds if you still wish to incorporate it into your investment plan. These funds allow you to explore the strategy while a professional fund manager handles the investment decisions on your behalf.

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