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The Basics of Momentum Investing – Make it work for you

Buying low and selling high is the mantra of success in stocks. How about the idea of ‘Buying high and selling higher’ or ‘Selling low and buying lower’? Do not get confused. Welcome to the world of momentum investing.

Momentum investing aims at making money by betting on the possibility that an ongoing trend (or momentum) in the market will continue in the near future. For example, there is high expectation that a company’s share price which has been rising in recent weeks may continue to go up in future. In a similar context, there is an expectation that the price of a company’s stock or an asset class, which is falling may continue to drift lower.

In India, like investors who fall prey to sentiment, savvy investors, also latch on to momentum investing. The idea is to be with the trend and benefit from ‘amplified outcomes’. If an investor buys a stock or a portfolio of stocks which is rising faster than the average market, then she is likely to make more money than those invested in the broad market. The Nifty 200 Momentum 30 index’s returns grew at Compounded Annual Growth Rate (CAGR) of 17.48% as it went up to 12070 on 11 September 2020 from 1000 as on April 1, 2005. In the same period, the Nifty 200 index’s returns grew at  CAGR  of 11.26% as it climbed to 5933 from 1139.

Followers of momentum investing must not randomly select rising stocks. Investors need to clearly know the parameters to define momentum. It can be a simple yardstick such as the price movement in the past six months or one year. Investors can also select stocks on the basis of technical indicators such as moving averages. Those stocks that top the gainers charts can be the rising momentum stocks on that day. Remember this list will change almost every day. A basket of top 10 or 30 stocks with equal allocation to each one of them depending on your investment corpus can be bought. The portfolio can be reset at a regular interval—say each month by following the defined process. If investors are comfortable going short on stocks using futures, then they can short weakest momentum stocks – the top losers.

The idea of buying rising stocks and shorting falling stocks may look logically convincing. But it comes with a caveat. Investors have to respect price action and they should get position size correct, after factoring in their risk taking ability and their corpus size. To make money from momentum investing investors have to take a longer term view. In the short term, this strategy comes with extreme volatility. There is a possibility of large drawdown compared to other strategies such as market cap weight driven index investing.

To contain the downside, investors who follow data bring in some ‘quality’ element in momentum investing. For example, instead of using stocks with absolute highest return, a more evolved approach is to use volatility adjusted return or Sharpe—absolute excess return over the past 52 weeks divided by the annualized standard deviation of daily price movements. Some may want to rank stocks by multiplying absolute returns with the percentage of up-days in the past six months or twelve months– the time frame in question while computing gains. Such approach ensures that more volatile names are dropped and only those stocks that are moving in the desired direction with less volatility feature in the momentum portfolio.

Such portfolios help investors contain the downside. But there is no assurance of safety of capital. A back-tested strategy can help investors set their expectations right. However, there can be a difference between the result of back-testing and actual returns owing to factors such as execution problems, faulty historical data and changing dynamics of the market. Like any other strategy momentum strategy may not work in certain market situations, say, for instance, when the markets move sideways. Hence, it is important that investors must have a long term view on markets. In the long-term, the strategy of making impressive returns plays out well across market cycles.

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