Momentum Investing: Meaning, Pros, and Cons

May 17, 2022 3 min read

Momentum Investing: Meaning, Pros, and Cons

Momentum Investing: Meaning, Pros, and Cons

In the past few decades, there have been fluctuations in the all-time highs in the S&P 500. However, in 2017, the all-time highs reached 50, the highest so far. When this happened, there was only one explanation – Momentum. 

What is Momentum? 

Momentum is an academic risk factor that affects the all-time highs of the S&P 500. It follows Newton's First Law of Motion: "an object will continue to stay at rest unless an object in motion acts on it." In this case, Momentum is the object in motion, and rising market prices mean more buyers while falling prices mean more sellers. In short, it is the factor solely responsible for bull and bear markets. 

What is Momentum Investing?

When it comes to mutual funds or securities, Momentum takes its course. It is a tool that can be used to describe an individual investment's performance. As an academic risk factor, it predicts the performance of stocks from recent performance, i.e., if it performed well, it would continue that way; if it does bad, it will continue that way. 

Thus, investing in stocks during any of its performance with Momentum taking its course is called Momentum Investing. 

According to Eugene Fama, who described the Hypothesis of Efficient Market, he said: "Momentum is the best description of a premier market anomaly. The returns of stocks in the previous year are likely to be the same in the coming months – low stock returns last year mean low returns over the next six months or less, while high stock returns last year mean high returns over the next six months or less." In short, the con of Momentum Investing is that it can predict the returns of stocks over the next few months. 

In a recent Research Affiliates Paper, the impact of momentum in mutual funds was reported as thus: 

"No U.S.-benchmarked mutual fund with "momentum" in its description has totally outperformed its benchmark since inception, net of fees and expenses. It got worse that the standard momentum factor left so much vacuum in the last momentum crash (between 2008–2009), it remains ignored in the United States, compared to its 2007 performance peak and its 1999 peak. In short, it means there was no alpha for 18 years before trading costs and fees were being subtracted."

While Momentum Investing has its pros, it also has cons. 

First, it often needs a large turnover. It does because there are likely chances that the valuable and high-performing assets can change over time, especially during lookback seasons. It takes longer. It cannot be applied for short-term individual investments or securities. 

Secondly, hedge funds and momentum investing are two opposite concepts of investing. If you are on hedge funds, you can take momentum investing. More often than not, trading experts take advantage of the momentum investing concept by utilizing the trend-trading strategy depending on the fluctuation of securities such as bonds, stocks, etc. 

Nonetheless, incorporating this investing strategy might be the perfect way for investors to have a more diversified portfolio.

Momentum Investing vs Value Investing

Apart from learning about momentum investing pros and cons, you should also know how they differ from Value Investing. 

Over the past few years, there have been debates about which is superior – momentum investing vs value investing. The results are often inconclusive. 

Value Investing is a concept that talks about trading stocks and other securities below intrinsic value. It is believed that stocks with low valuation ratios are much better than high valuation types. People like James O'Shaughnessy, and Warren Buffet are notable personalities who have this ideology. 

On the other hand, Momentum Investing focuses on three main things – technical patterns (strong), performance, and strength. In short, it doesn't dwell on the intrinsic value of stocks like the former. 

Momentum investing concept dwells on an acronym coined by William J O'Neil – "CANSLIM." 

C – Current or Quarterly Earnings Comparisons (100% or more)

A – Annual Earnings Growth (25% or more)

N – New Product or New Management

S – Shares Amount (heavy or low demand)

L – Leader (Stock)

I – Institutional Ownership of Stocks

M – Market 

Many people have believed combining the best attributes of the duo. That is: buying stocks based on intrinsic value and performance. A tool like the Gunderson Grade System might just be the perfect way for you to find such stocks. 

Some top-rated stocks in this category include Ezcorp Inc., Green Mountain Coffee, Tractor Supply, First Cash Financial, and Carbo Ceramics. 

Overall, it is possible to be a momentum investor and a value investor.