Momentum Investing: In 90 Seconds or Less

Think of momentum investing as kind of like being the New England Patriot’s of investing. The premise is an extremely straightforward one. Winner's keep winning (and losers keep losing).

There are as many ways to use this strategy as there are ways to bake a cake. So let's simplify things by looking at one of the most common ways people use momentum strategies--Moving Averages.

Say you've got extra money lying around and you've found a stock you may want to invest in. You then watch that stock for 200 days before pulling the trigger and investing. During this time period, the price of the stock will invariably fluctuate. But there will be an average price the stock trades at during that time. This is the 200-day Moving Average. And it's one of the more common ways to trade on momentum.

A momentum investor would purchase this stock when it's price goes above the 200-day Moving Average. And would sell when the price drops below the 200-day Moving Average. If you're thinking this would create a lot of buying and selling, you're right. After all, how would the stock have time to win (or lose) if you're constantly buying/selling? That would be like replacing Tom Brady every time he threw an interception. That is if Tom Brady ever threw an interception.

To fix this problem, investors will set rules for themselves. For instance, they will only trade on the last trading day of the month. On this day, if the stock is above the 200-day average, they will purchase it. If the stock is below the 200-day average, they will sell it and move the money to cash until it passes above the "trend line" again. The belief is that trends tend to continue for some time. And investors can profit from following these trends.

This is the exact opposite of the strategies used by Fundamental Investors. Those who believe that criteria such as company earnings, market price, debt, and leadership are what determines which stocks to buy and sell. Or buy-and-hold investors. Those who believe that market-timing strategies (which this is) do not create better risk-adjusted returns. I'd imagine that for these groups when momentum investing works, it's a bit like watching your least favorite co-worker continue to get promoted. Or your least favorite quarterback keep winning Super Bowls...

And that's momentum investing.

*These are the general views of Stanton Burns and they should not be construed as investment advice for any individual. Opinions expressed are subject to change without notice and are not intended as investment advice or to predict future performance. Stanton Burns does not maintain positions in any securities mentioned as of the writing of this article. Past performance is historical and does not guarantee future results.