Momentum investing bets on a specific and somewhat counterintuitive premise for efficient-market theory — that stocks which have recently performed well tend to keep performing well, at least for a while.
The Approach and Risk
Momentum investors buy stocks showing strong recent price and earnings trends, on the thesis that institutional buying interest, positive sentiment, and earnings momentum tend to persist in the near term rather than reverse immediately. The documented risk: momentum can reverse sharply and without warning once sentiment shifts, and a momentum-driven stock trading well above its fundamental value carries genuine downside risk if that momentum breaks.
One thing worth checking: A disciplined momentum strategy typically pairs trend-following entries with a strict predetermined exit rule (a stop-loss or trailing stop) — since momentum's risk is a sharp, fast reversal, having a genuine predefined exit plan before entering matters more here than in most other strategies.
Someone Considering Momentum Investing: Set a predetermined exit rule before entering — momentum reversals can be fast.
Someone Uncomfortable With Sharp Reversal Risk: A more fundamentals-anchored strategy may suit your risk tolerance better than pure momentum.
Approach Momentum Investing the Way
- Set a predetermined exit rule before entering a momentum position.
- Confirm the trend with volume, not price alone.
- Size positions accounting for genuine, fast reversal risk.
See contrarian investing strategy for the opposite approach.
