What Is Momentum Investing?

If the market is doing well, some say it may be best to invest more.

Stock Market Capitalization
••• Justin Guariglia, Getty Images

Should you buy stocks when they’re heating up and then sell them when they’ve cooled off?

That’s the opposite of some conventional wisdom, but it’s the basic philosophy behind one investing approach that has shown some ability to beat the overall stock market, but not without some risk.  

Momentum investing is a concept based on the idea that you can earn long-term profits by riding stocks while they are on a good run, and selling them once they’ve had a long bad stretch. In most cases, an investor deploying this approach will buy stocks that have had high returns for between three to 12 months and sell those that have underperformed during that same period.

It’s unclear who “invented” momentum investing, but it’s widely acknowledged that Chicago-based fund manager Richard Driehaus was one of the first to tout it widely.

“I believe that more money can be made buying high and selling at even higher prices,” Driehaus told Crain’s Chicago Business in 2004. “I try to buy stocks that have already had good price moves, that are often making new highs and that have positive relative strength.”

Momentum Investing and Conventional Wisdom

There is no broad consensus as to whether momentum investing is a valid strategy, but the concept gained steam in 1993 after researchers noted in the Journal of Finance that if an investor purchased past winners and sold past losers, they would have received “significant abnormal returns” between 1965 and 1989.

Even those who believe in momentum investing can’t entirely explain why it works when it does. But, it does fly in the face of some conventionally held philosophies.

Momentum investing is essentially the opposite of the old adage that investors should “sell high” and “buy low.” If an investor purchases a stock that has had high returns over a period and sells those that have been performing poorly, it’s safe to ask whether they are taking advantage of the best pricing.

Momentum investing also goes against the “buy and hold” approach, which simply focuses on purchasing shares of quality companies and holding on to them for very long periods.

Momentum Investing Returns

One way to track the success of momentum investing is to look at the MSCI USA Momentum Index, which is designed to emphasize stocks with rising prices.

Here’s a look at the annual performance of the MSCI USA Momentum Index compared to its parent index, the MSCI USA Index, as well as the S&P 500, dating back to 2008 (the year of the financial crisis).

Year MSCI USA Momentum Index MSCI USA Index S&P 500
2018 -1.61 -4.50 -4.38
2017 37.82 21.90 21.83
2016 5.13 11.61 11.96
2015 9.30 1.32 1.38
2014 14.69 13.36 13.69
2013 34.80 32.61 32.39
2012 15.10 16.13 16.00
2011 6.09 1.99 2.11
2010 18.21 15.45 15.06
2009 17.64 27.14 26.46
2008 -40.89 -37.14 -37.00

As you can see, the MSCI USA Momentum Index beat the other two indexes in seven of the last 11 years. However, it is notable that during the year of the financial crisis in 2008, the index performed worse than other indexes. This lends credence to one notion that momentum investing can add to growth during periods of good stock market growth, but fails to protect capital well during bad times.

“It doesn’t work in every market environment,” noted an article last year published by the UCLA Anderson School of Management.  “And momentum stocks are subject to sharp reversals that can leave trend-followers badly bloodied.”

How to Follow a Momentum Approach

One drawback to momentum investing is that it can require a good deal of work. Not all investors have the time, energy, or expertise to research which stocks have been on a good run and which have not. In fact, true momentum investing involves following certain complex technical indicators that tell you when to buy and sell a security.

But, the momentum philosophy can be applied in a general way, with investors putting more money into stocks when the overall market is doing well and staying away when it’s not. (In other words, don’t worry about picking specific stocks, but ride the trends.)

For those who aren’t keen on picking stocks, there are specific securities that follow a momentum approach. In recent years, the market has seen a wave of exchange-traded funds that focus on picking stocks with good recent performance.

Examples include the iShares Edge MCSI U.S.A. Momentum Factor ETF [BATS: MTUM] and the SPDR Russell 1000 Momentum Focus ETF [NYSE ARCA: ONEO].

These ETFs can help someone use a momentum investing approach without selecting individual securities. They can also help you save money, as the ETFs will adjust their holdings on their own, thus freeing you from the commissions and tax implications that often come with frequent buying and selling.