Understanding Momentum investing

Momentum investing is a type of investment strategy in which individuals attempt to purchase stocks that are already performing well and then sell them at an even higher profit. This is essentially like riding the wave of the trend and cashing in quickly. Momentum investors can potentially make substantial returns if the strategy is implemented correctly. Here are the basics of momentum investing and how it can work for investors. 

Momentum Investing

With this investment strategy, individuals try to locate stocks that have been performing well for somewhere between 3 and 12 months. At the same time, they will sell stocks that have not performed well over this period. They will buy these stocks that are performing well and hold them until it appears that they are about to go back down. They will look for market conditions that give an indication that the stock is about to decline in value before selling. At that point, they will take their profit and purchase another stock that is on the way up. With this strategy, you are continually working with companies that are doing well and avoiding companies that are on their way down.

Two Theories of the Effect of Momentum Investing

Economists have developed two theories about why momentum investors are successful. The first theory is that these investors are simply realizing a larger return because of the large amount of risk that they are taking on. The other theory says that these traders are taking advantage of the wrong behaviors of other, less experienced traders in the market. For example, when a good financial analyst comes out with a positive report on a company, many people overreact to that news. This report can drive the price of the stock up even further than it should go. The momentum investor realizes this and takes advantage of the opportunity.

Seasonal Effects

Seasonal effects can also have an impact on individuals that practice this strategy. For example, when a company has performed well over the course of year, many people will still sell the stock when it gets close to the end of the year. They do this for tax purposes. When this happens, the value of the shares will decrease, which gives other people a chance to buy the stock.

Potential Drawbacks

Even though this investing strategy can be very profitable, it does have a few potential drawbacks that you should be aware of. First of all, it can be difficult to time this type of investment. If you are an individual trader, you do not have access to the information that institutional traders do. Institutional traders who practice momentum investing may already be getting out of an investment that appears to be sound to you. At that point, you will lose money on the trade while they get out. 

Another disadvantage of this strategy is that you will have to deal with transaction costs. The transaction costs will eat into your profitability overall.

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