Momentum investing rests on a simple observation that has puzzled economists for decades: assets that have been rising tend to keep rising for a while, and assets that have been falling tend to keep falling. Rather than hunting for bargains, momentum investors buy what is already working and avoid what is not. It is one of the most widely used strategies in professional investing, and it comes with a sting in the tail.
How momentum works
A momentum investor typically ranks assets by their performance over a recent period, often the past three to twelve months, and buys the strongest performers. Some strategies also sell or avoid the weakest. Positions are reviewed regularly, so the portfolio rotates into whatever is leading at the time.
The idea is not to predict the future from fundamentals, but to ride trends that are already in motion.
Why momentum exists
There are a few common explanations. Investors often under-react to good news at first, so prices adjust gradually rather than all at once. Success attracts attention, bringing in new buyers. And professional funds that benchmark against an index may feel pressure to own the winners, adding to demand. Together, these forces can keep a trend going longer than many expect.
Momentum in action
Over the past few years, technology and artificial intelligence stocks have been classic momentum trades. Strong results attracted buyers, rising prices attracted more buyers, and the trend fed on itself. It is a powerful dynamic while it lasts.
The sting: momentum crashes
The weakness of momentum is that trends end, and they can end abruptly. When a crowded momentum trade turns, everyone tries to exit at once. Prices can fall faster than they rose. These sudden reversals are known as momentum crashes, and they tend to happen when the mood in markets shifts quickly, for example when worries about valuations, interest rates or growth suddenly come to the fore.
The sharp sell-off in chip stocks this week, covered in our Morning Market Brief, shows how quickly popular trades can unwind. Our guide to crowded trades explains why this happens.
Momentum versus value
Value investing does the opposite of momentum: it looks for assets that have become cheap, often because they have fallen out of favour. The two styles tend to take turns leading. When momentum is working, value can feel painfully slow. When momentum cracks, value often shines.
How traders manage momentum risk
- Use stop-losses or trailing stops to protect gains when a trend reverses.
- Size positions carefully so that one reversal does not do lasting damage.
- Watch for signs of exhaustion, such as falling volume on rallies or shares failing to rise on good news.
- Diversify across different assets rather than concentrating in one hot theme.
The takeaway
Momentum is a genuine force in markets and can be profitable, but it rewards discipline. The trend is your friend only until it ends, and the exit matters as much as the entry.
If you want to know how well your own approach handles trends and reversals, take the free Samuel & Co Trading Trader Assessment.
