Momentum Investing
Focus on assets showing strong relative price performance.
What Is Momentum Investing?
Momentum investing is based on the observed tendency of assets that have shown strong recent performance to potentially continue exhibiting relative strength for some period, and for weak performers to potentially continue underperforming.
Momentum does not always work, and it involves significant risk. It is based on an observed pattern in price/performance behaviour over some historical periods, not a guarantee about future behaviour.
Basic Approach
- Screen a universe of assets for recent performance
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- Identify relative strength — assets performing strongly relative to peers or a benchmark
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- Enter positions according to predefined rules
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- Monitor ongoing performance
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- Exit or rebalance according to the strategy's rules
What Investors Are Trying to Achieve
The goal is to systematically hold what has recently been performing relatively well, and avoid or exit what has recently been performing relatively poorly, based on a defined, rules-based process rather than a view on any individual business.
Important Concepts
- Relative strength — how an asset has performed compared with peers or a benchmark
- Trend — the general direction of price movement over a defined period
- Entry rules — the defined conditions for starting a position
- Exit rules — the defined conditions for closing a position
- Rebalancing — periodically updating which assets are held based on updated performance
Practical Example
Hypothetical illustration only. An investor periodically ranks a group of assets by their performance over the past several months, holds the top-ranked group for a defined period, and rebalances at fixed intervals — replacing assets that have fallen out of the top-ranked group with ones that have entered it. This is a rules-based process, not a judgement about any individual business.
Advantages
- A defined, rules-based process that does not depend on forecasting a business's fundamentals
- Can be applied systematically and tested against historical data
- Responds to observed price behaviour rather than requiring a fundamental view
Risks
- Reversals — recent strong performers can underperform sharply once a trend ends
- Whipsaws — frequent entry/exit signals in choppy markets can generate repeated losses
- Transaction costs — a rules-based process with regular rebalancing can accumulate costs over time
- Timing risk — entry and exit rules can trigger at unfavourable points
- Crowded trades — if many participants follow similar signals, moves can become more extreme
- Volatility — momentum-based portfolios can be more volatile than the broader market
Common Mistakes
- Assuming momentum always continues — reversals happen, and can happen abruptly
- Ignoring transaction costs when comparing a momentum strategy's returns with alternatives
- Following signals inconsistently instead of applying the defined rules systematically
- Confusing momentum with a fundamental view on the underlying business
- Underestimating how a strategy performs in a genuinely trendless or choppy market
Momentum Investing vs Value Investing
Momentum vs Value Investing
| Feature | Momentum Investing | Value Investing |
|---|---|---|
| Basis for decisions | Recent relative price performance | Estimated gap between price and fundamental value |
| Underlying view | Recent strength may persist for a period | Price may converge toward estimated value over time |
| Typical holding period | Often shorter, rules-based rebalancing | Often longer, tied to a fundamental thesis |
| Main risk | Sudden reversal of the recent trend | The estimate of value being wrong |
| Process style | Systematic, rules-driven | Research-driven, business-specific |
Backtesting a Momentum Approach
Because momentum rules are systematic, they can be tested against historical data to see how a defined rule set would have behaved in the past — with the usual caveat that past behaviour does not predict future results. FinverseLab's historical backtesting tools can be used to explore how a rules-based approach would have performed historically on the instruments currently covered.
Explore the Historical Backtesting LabWho May Find This Approach Useful
- Investors comfortable with a systematic, rules-based process rather than fundamental analysis
- Investors who accept higher turnover and transaction costs as part of the approach
- Investors able to tolerate the risk of sharp reversals
Who May Prefer a Different Approach
- Investors uncomfortable with frequent rebalancing and its associated costs
- Investors who prefer decisions grounded in business fundamentals rather than price behaviour
Key Takeaways
- 1Momentum investing follows the observed tendency of recent strong (or weak) relative performance to continue for some period.
- 2It is a systematic, rules-based approach — screening, entry rules, exit rules, and rebalancing — not a fundamental view on a business.
- 3Momentum does not always work and involves significant risk, including sharp reversals and whipsaws.
- 4Transaction costs from frequent rebalancing can meaningfully affect net returns.
- 5Momentum and value investing rely on different, sometimes opposing, assumptions about price behaviour.
- 6Because the rules are systematic, momentum approaches can be examined using historical backtesting.