Have you ever heard of momentum investing?
Basically, this is the belief that when a stock goes up, it will continue to go up. And, if the stock is taking a dive, you would expect it to continue to go down, and you would invest accordingly.
This term has been quite popular as of late, and for good reason too. In 2013 alone, the DOW index increased by over 26.5% and had carried some serious momentum throughout the entire year.
By December 31, 2013, the DOW had closed at an all-time high, $16,576.66. If you believed in momentum investing during 2013, you would have earned yourself quite a lot of money.
How to Invest as a Momentum Investor
So if a stock has been going up, what do you think you would do as a momentum investor? Yup, you buy it! If you want to buy more than your cash can get you, then you might want to buy a call option which will pay off if your stock hits the target price that is set on that option.
Pretty easy, right? If you see a stock that has increasing momentum in value, then you would likely buy it and expect that trend to continue. You then sell it when you make the amount of money that you were looking for and move on to another stock.
So what if a stock is going down in value and has downward momentum? Many people would assume that there is no way to gain from this movement because you obviously don’t want to buy the stock on the way down. If it continues to drop in value, you’re going to lose money!
There is actually a way to profit from this occurrence, however: you can short sell the stock. In other words, you can borrow the shares from your broker, sell them (without buying them first) and then buy the stock and return the shares to your broker at a later (predetermined) date (hopefully at a lower value than what you sold them for in the first place.
So, if the stock has been going down and you expect this trend to continue, then you could short the stock to earn your returns. Whether the stock is going up or down, if you get the feeling that the stock will continue to move in that direction, you can make a transaction and potentially profit from it.
In 2013, the trend was often rising, so investors purchased many shares of stock and were happy to see that the stock continued on that pattern. The reason that you may have heard the term, “momentum investing,” is because of the large returns that were earned within that magical year.
Is It Wise to Invest on Momentum?
While momentum investing worked well in 2013, there is no guarantee that it will continue to work that well in the future. You have most likely heard the popular phrase, “Buy low, sell high.” It is a very simple concept, but it makes complete sense.
When you buy shares of stock, you want to buy them for a deal. When you are ready to sell them (perhaps as you start retirement), you want those shares to be worth much more than you originally bought them for. So is momentum investing the answer? Based on my experience, I say, “No.”
When you start looking at momentum investing, you actually don’t start to invest in a stock until it has shown an upward trend for a period of time. There are times when you might hop into the market (because of this upward-trending stock) and then it hits its high point and begins to go down again.
In my experience, when a stock value has been rising for a few months, I naturally expect it to go down in value. No matter how good a company is, there are only so many times that they can beat the expectations of “the street.” Eventually (typically sooner rather than later), a company will not be able to keep up with the hype they have produced for themselves, which means that their stock will begin to tumble.
If you don’t want to believe me, then perhaps you will listen to a man by the name of Warren Buffett. Warren is a believer in buying companies that have value and are solidly managed. Momentum investing is based on short-term movements and quick decisions.
Mr. Buffett has created billions of dollars of net worth because he believes that the only way to invest is for the long-term. Short-term gains are risky and can quickly turn from huge positive returns to devastating negative losses.
The decision is ultimately up to you. There are definitely people that are profiting from this style of investing, but will they continue to earn positive returns?
What about you? Would you invest based on momentum?
Robert Farrington is America’s Millennial Money Expert® and America’s Student Loan Debt Expert™, and the founder of The College Investor, a personal finance site dedicated to helping millennials escape student loan debt to start investing and building wealth for the future. You can learn more about him on the About Page, or on his personal site RobertFarrington.com.
He regularly writes about investing, student loan debt, and general personal finance topics geared towards anyone wanting to earn more, get out of debt, and start building wealth for the future.
He has been quoted in major publications including the New York Times, Washington Post, Fox, ABC, NBC, and more. He is also a regular contributor to Forbes.