What is momentum Investing?

Momentum investing is a strategy that involves buying securities that have had high returns over a recent period, typically three to twelve months, and selling those that have had poor returns over the same period.

The core idea is that stocks that have performed well recently will continue to do so in the near term, while those that have underperformed will continue to lag.

 Benefits of Momentum Investing

1. Potential for High Returns: Momentum investing has historically outperformed the market. By capitalizing on existing trends, investors can ride the wave of upward momentum, potentially achieving higher returns than those who follow a more passive investment strategy.

2. Behavioural Finance Justification: Momentum investing leverages the behavioural biases of investors. Herding behaviour and the tendency of investors to follow the crowd can create trends that momentum investors can exploit. Additionally, the disposition effect, where investors hold onto losers too long and sell winners too quickly, can also contribute to momentum.

3. Systematic Approach: Momentum investing can be systematized and implemented using quantitative models. This allows for a more disciplined approach, removing emotional biases from investment decisions. Such systematic strategies can be backtested, giving investors confidence in their methods based on historical data.

4. Diversification: Momentum strategies can be applied across different asset classes, including stocks, commodities, and currencies. This diversification can reduce risk while maintaining the potential for high returns.

 Drawbacks of Momentum Investing

1. Risk of Reversals: Momentum investing is inherently risky because trends can reverse abruptly. Events such as earnings announcements, geopolitical developments, or market corrections can cause rapid changes in price direction, leading to significant losses for momentum investors.

2. Market Timing: Successfully implementing a momentum strategy requires precise timing. Getting in too late or exiting too early can erode profits. Timing the market consistently is challenging, even for experienced investors.

3. Transaction Costs: High turnover is a hallmark of momentum investing, as it involves frequent buying and selling to capture the trend. This can lead to substantial transaction costs, including commissions, bid-ask spreads, and taxes, which can eat into profits.

4. Overfitting in Quantitative Models: There is a risk that the quantitative models used to identify momentum might be overfitted to historical data. This means that the model might perform well on past data but fail to predict future performance accurately.

5. Market Efficiency: Critics argue that momentum investing contradicts the efficient market hypothesis (EMH), which states that all known information is already reflected in stock prices. If markets are efficient, consistent excess returns from momentum investing should not be possible. As markets evolve and more investors adopt momentum strategies, the opportunities for excess returns may diminish.
   

Some Momentum Funds Performance

ICICI Prudential Nifty 200 Momentum 30 Index Fund – Regular Plan (G)

RETURNS (NAV as on 19th June, 2024)

Tata Nifty Midcap 150 Momentum 50 Index Fund – Regular Plan (G)

(as on 19th June, 2024)

UTI Nifty 200 Momentum 30 Index Fund – Regular Plan (G)

(as on 19th June, 2024)

Conclusion

Momentum investing can be a profitable strategy when executed correctly, leveraging trends and behavioural finance insights to achieve high returns.

However, it carries significant risks, including the potential for abrupt trend reversals and high transaction costs. Investors must carefully consider these factors and possibly combine momentum investing with other strategies to mitigate risks and enhance overall portfolio performance.